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Towards an evolutionary approach of financial markets

If the prices of assets include all available information at every moment, then we can only beat the market by coincidence…

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Standard models in finance have something very sad in them. Indeed, financial theory teaches us that markets should converge towards efficiency. This term is used to describe the situation where asset prices should at any moment include all available information. If this is indeed true then we can only beat the markets by coincidence. It is however worthwhile noting that information is only defined in relation to an equilibrium model. We therefore suppose that economic agents learn quite quickly about the underlying economic structure and that the latter remains relatively stable. There can be what economists call shocks but the structural relationships are supposed to be stable. Besides, we suppose that the heuristics are more or less the same for all economic agents meaning that they more or less use the same statistical and rational approach which is supposed to be objective. This brings us to models such as the CAPM (Capital Asset Pricing Model) which establish the relation between asset profitability and systematic risk.

The stability of the system also implies a certain degree of stability in the preferences of investors. However, recent research in neurosciences highlight the fact that investor behavior is very different from what is supposed by economic theory. The standard approach supposes most notably that economic agents make rational and conscious decisions by evaluating event probability and wellbeing assessments in different situations. For example, what is the probability that the market goes up or down and what are subjective profit or loss values? Neurosciences on the other hand teach us that the brain can be divided in three regions. The first one is the “reptilian” brain which is considered as the most ancient one and the one which regulates breathing and heart beats. The “mammal” brain in which instincts and feelings are lodged and finally the “hominid” brain which is the part overlooking rational decisions.

Taking this division as a base, neurosciences use different techniques in order to isolate active regions during specific problem solving. Therefore, when individuals are faced with decision making or investment problems, probability knowledge of the various scenarios has an impact on the active part of the brain. When probabilities are known, more recent regions of the “hominid” brain are active. Why is this observation important? Well if decisions where probabilities are unknown mobilize regions of the “mammal” brain, then it not guaranteed that those choices respect mathematical axioms which are located in the “hominid” part of the brain. It is exactly what we observe in the sense that the choices of individuals often do not respect basic probability axioms.

It is true that individuals, in general, display a number of cognitive anomalies. We notably note a tendency towards overconfidence. This results from a habit in individuals to associate largely random positive events to superior abilities. Besides, psychologists who are specialists in random behavior have noted that individuals often have a hard time setting aside value judgments when taking decisions in uncertain situations. This leads to behaviors that are contrary to basic axioms of probability theories. Finally, the same psychologists also note the fact that individuals have asymmetric behaviors when faced with profits and losses. It was seen that they are risk averse when faced with gains but are “risk lovers” when dealing with losses. It can be shown that this type of behavior can lead to the creation of suboptimal portfolios.

Neurosciences help better understand what causes this sort of “irrationality”. In this respect, we take the hypothesis that the tri structure of the brain (“reptilian” “mammal” “hominid”) is the result of an evolutionary process in which the basic survival functions have appeared first then social behaviors and finally intellectual abilities. This implies that the “mammal” part and the “hominid part are often in contradiction. This is namely the case when emotions take precedence over rational decisions. It is however worthwhile noting that the function of emotions is among other things to take quick decisions when a rational one would take too much time (for example: when facing a dangerous animal). That said, reactions often lead to non-optimal behaviors when considering our current environment.

In all cases, what is termed “preferences” by economists is in fact the result of complex interactions between different regions of the brain. This observation is not trivial since it implies that these “preferences” are not necessarily stable over time and can depend on a lot of factors linked to the decision maker’s personality and his environment. These “preferences” would in fact be evolutionary and would adapt to the environment. These “preferences” bring some researchers, namely A.W.Lo to consider the adaptable financial markets as an alternative approach to market efficiency. The markets would therefore be faced to a natural selective evolutionary process and behavior adaptation. This would mean that those who would have an irrational behavior would be gradually eliminated from the market. The term gradual is important since the market is no longer efficient at every moment but tends progressively towards more efficiency. The corollary would that contrary to what is taught by standard academic literature, there is room for active asset management that has value added. We can then beat the market !

Michel Verlaine , March 2008

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