What’ve ants got to do with it?

MUMBAI: One of my professors had this habit of remarking “ Since we are all born on this mother earth, there is some sort of synergy between us”. What he probably meant was “ Individuals do not act in isolation, but affect each other in complex ways”, as Paul Ormerod writes in the book “Butterfly Economics”.

Ormerod points out about a very interesting piece of research that was carried out on ants in the mid eighties. Essentially two similar sources of food were placed at the same distance from a nest of ants. Also every time an ant removed a grain from one of the sources it was replenished so that the two sources of food remained similar. This was to ensure that the ants had no reason to go to one source over the other. The question that the researchers were trying to investigate was “ How would the ant colony divide itself between the two sources of food?”.

Both the sources of food were similar. Hence there was really no reason that the ants prefer one source of food over another. So as per this, they should have divided themselves equally between the two sources of food. But that was not what happened. As Ormerod writes “ A little reflection would lead us to think that, while this might very well be an outcome, any division would be possible. Suppose each ant emerges from the nest and visits one of the food piles at random. It is successful in obtaining food to bring back to the nest, and so on its next outing it has an incentive to revisit the site of its previous success. The pile is always replenished, so it will always obtain food from this site”.

So once an ant had found food at one of the sources of food, it would keep returning to it. More than this, it was observed that some ants would stimulate other ants to follow them to one of the sources of foods through chemical secretion. Some other ants would recruit entire groups to follow them by leaving a trail of secretions. As Ormerod writes “ So an ant emerging from the nest for the first time would be influenced in its decision by the trail of ants it encounters on its journey”. What this obviously led to was that more the number of ants that visit a particular source of food, greater was the chance that even more ants would visit the site, in the future. The random choice of the first few ants leaving the nest have a decisive influence on how the remaining ants behave.

Much like the ants, investor decisions are also made in a sequence. Some investors who invest in the stock market during a bull run, assume that investing in the stock market is a good bet simply because some of the people they know have already done the same and made profits.Consequently, during a bull run the stock market has more buyers than sellers. Expectedly, stock prices zoom up. Expecting the bull run to continue, more and more investors enter the market, fuelling an even greater price rise and this cycle gets repeated. Riding the bull wave, stock prices of fundamentally weak stocks also start to go up.

Going back to the ant experiment, something really interesting was observed. As Ormerod writes “ Once a large number of ants had visited  one of the sites, the outcome tended to stay reasonably stable and exhibited small variations around the proportion for some considerable time. But the majority was always eroded and the ants switched to the other site. Sometimes, these shifts were not only very large from say, an 80:20 division at one pile to the reverse outcome of 20:80 - but also rapid”. The explanation provided for this is “An ant coming out of the nest follows one of three possibilities: it visit’s the food pile it previously visited; it is persuaded by a returning ant to visit the other source; or, of its own volition, it decides to try the other pile itself. And this is almost all that is required to explain the complex and seemingly baffling phenomenon of the fluctuations in the proportions of ants visiting the respective piles”.

So what have ants got to do with the stock market ? Over a period of time, an investor can continue behaving in the same way as before. Or he can change his behaviour simply influenced by the behaviour of other individuals around him. As Ormerod writes “The agent can be persuaded to switch by the behaviour of others - by the trails which they leave when their buy or sell decisions appear on the dealing screens”. So, as per theory, the price of a stock should really change when the fundamentals of the stock change. But that is really not how it turns out to be most of the times. Like ants, most investors get influenced by how others around them have been behaving. As Robert Shiller points out in Irrational Exuberance “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times.”

Stock market essentially has two kind of investors, those who invest for the long term and those who invest for the short term. As is the case with ants visiting the two food piles, the split between the long term investors and the short term investors keeps changing. At a given point of time, the market may be dominated by long term investors, but a switch to short term investors dominating is always possible. In times like these markets are extremely volatile. As Ormerod writes

“The very nature of the process dictates that some of these large changes will be very rapid, And, at these times, we are likely to see a large change in the price of the relevant asset, as it switches from being determined by fundamentals, say, to being generated by the exploration of its own past behaviour as chartists come to dominate this particular market”.  That to some extent should explain as to why the Sensex out of the blue fell by more than a thousand points in a few hours on a certain day in June and the exchange had to be shut down. And now, a few months down the line, it has covered up for all the losses.

The bottomline is that the way various participants in the market interact and the overall effect that it produces is very difficult to predict in the short term, CNBC notwithstanding. As Ormerod writes “Short- term prediction and control of overall outcome is either very difficult or impossible”.