Financial History 145 Spring 2023 - Page 14

What I Learned About Investing from Darwin

By Pulak Prasad
All investors make two kinds of mistakes . The first kind — dubbed a type I error by statisticians who can never be blamed for being creative — occurs when a person makes a bad investment because they erroneously think it is a good one . It is the error of committing self-harm and is also called a false positive or error of commission . A type II error occurs when a person rejects a good investment because they erroneously think it is bad . This is the error of rejecting a potential benefit and can be termed a false negative or error of omission . Every investor , including Warren Buffett , makes these two errors on a regular basis . They either harm themselves or walk away from a great opportunity .
As any statistician will tell you , the risk of these two errors is inversely related . Minimizing the risk of a type I error typically increases the risk of a type II error , and minimizing the risk of a type II error increases the risk of a type I error . Investors can ’ t have their cake and eat it , too ! They need to choose to be more sensitive to making one type of error while living with the consequences of making more errors of the other kind . What should one do ?
In other words , which of the following investment strategies should a person use : ( 1 ) making a lot of investments so as not to lose out on some good opportunities and , as a result , living with some failed investments , or ( 2 ) being highly selective to avoid making bad investments , thereby missing out on some good investments ?
Let ’ s turn to evolution to seek the answer .
Seeking Answers Through Evolution
The goal of all animals is to survive for as long as possible , at least until they reproduce . In the animal world , everyone is both prey and predator . Yes , even Homo sapiens . How are humans prey ? Remember COVID-19 ?
Let ’ s start with the prey . A type I error for a prey animal would equate to inflicting sufficient harm on itself to compromise its fitness .
Let ’ s take the case of an adult male deer who is thirsty and is near a watering hole . Borne by instinct or experience or both , the deer knows that the watering hole could sound its death knell if a lion or leopard or crocodile is hiding , waiting for the opportunity of an easy meal . If the deer chooses to approach the watering hole , it slakes its thirst quickly and then moves away . And if it mistakenly draws near while a predator is ready and waiting , its life ends .
From the fossil record , we know that the deer that we see today evolved from ungulates about 15 to 30 million years
12 FINANCIAL HISTORY | Spring 2023 | www . MoAF . org