Natural Selection

What Is Natural Selection?

In modern biology, natural selection is a process whereby species which have traits that enable them to adapt in an environment survive and reproduce, and then pass on their genes to the next generation. Natural selection means that species that can adapt to a specific environment will grow in numbers and eventually greatly outnumber those species that cannot adapt.

The natural selection process enables a species to better adapt to its environment by changing its genetic configuration with every new generation. These changes are gradual and may occur over thousands of years, although in some instances natural selection may occur much faster, especially in species with short life spans and rapid reproduction rates.

When natural selection is applied conceptually in the field of finance, the assumption is that over the long term, only those companies that can respond and successfully adapt to changes in the financial and business environment will survive.

Understanding Natural Selection

One of the most well-known examples of natural selection in the field of biology is that of the English peppered moth. Although the English peppered moth has always existed in a variety of colors, until the Industrial Revolution in England, the light gray, spotted variety was the most abundant. That's because these moths could easily camouflage against the background of a lichen of a similar color that grew abundantly in their environment. Conversely, dark-winged versions of the moths were easy targets for birds and other predators.

The Industrial Revolution, which occurred between approximately 1760 and 1840, produced massive amounts of air pollution. This air pollution killed some of the lichen-covering of rocks in the moths' environment. At the same time, some lighter-colored buildings turned black from air pollution. As a result, the lighter gray-colored moths could no longer blend in with their surroundings as easily and were more readily spotted by predators, which led to their near-extinction. The dark-winged variety was now better-camouflaged and ended up surviving in greater numbers than the light-winged variation of the moth.

When applied in a financial context, natural selection means that, due to the dynamism and complexity of the business environment, only a handful of companies can remain in business for long periods of time. Companies that don't adapt may experience a potentially decreasing market share due to increased or improving competition. Over a period of time, if a company is unable to adapt, they may end up in bankruptcy. If a trader or investor doesn't adapt to changing market conditions, they will lose money, and if they fail to adapt over an extended period of time they may be forced out of the market as their capital dwindles to nothing.

Natural selection is a dynamic and ongoing process. While the ability to adapt to recent changes in the industry may be a good indicator of a company's or trader's overall aptitude, it does not guarantee that they will be able to adapt to all future changes in the business environment.

Example of Natural Selection

During the credit crisis of 2008, several brokerage firms suffered a similar fate of bankruptcy. As a result of this dramatic deterioration in the financial landscape, Bear Stearns (founded in 1923), Merrill Lynch (founded in 1914), and Lehman Brothers (founded in 1850) were all unable to retain the independence they had experienced for decades. They were all either acquired by larger banks (Bear Stearns by JPMorgan Chase, and Merrill Lynch by Bank of America) or forced into bankruptcy (Lehman Brothers).

The Bottom Line

Before the financial collapse of 2008, the collective assumption was that certain institutions were "too big to fail." Unfortunately, the events of 2008 proved that when it comes to natural selection, size doesn't always matter. Much more important is flexibility and the ability for a business or an investor to swiftly recognize and adapt to changing business environments.