This is an edited version of a talk given at the Robert C. Merton 75th Birthday Celebration Conference held at MIT on August 5 and 6, 2019. A video of the talk is available at https://bit.ly/2nvITM6.
This article is one of a pair of articles published in this volume about Robert C. Merton's contributions to the science of financial economics. The other article in this pair is “Robert C. Merton and the Science of Finance” by Zvi Bodie.
What is the interaction between competition, R&D investments, and the financing choices of R&D-intensive firms? Motivated by existing theories, we hypothesize that as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to assets-in-place that support existing products; (2) carry more cash; and (3) maintain less net debt. We provide causal evidence supporting these hypotheses by exploiting differences between the biopharma industry and other industries, as well as heterogeneity within the biopharma industry, in response to an exogenous change in competition. We also explore how these changes affect innovative output, and provide novel evidence that in response to greater competition, companies increasingly “focus” their efforts—there is a relative decline in the total number of innovations, but an increase in the economic value of these innovations.
In this article, the authors develop a data-driven peer grouping system using artificial intelligence (AI) tools to capture market perception and, in turn, group companies into clusters at various levels of granularity. In addition, they develop a continuous measure of similarity between companies; they use this measure to group companies into clusters and construct hedged portfolios. In the peer groupings, companies grouped in the same clusters had strong homogeneous risk and return profiles, whereas different clusters of companies had diverse, varying risk exposures. The authors extensively evaluated the clusters and found
that companies grouped by their method had higher out-of-sample return correlation but lower stability and interpretability than companies grouped by a standard industry classification system. The authors also develop an interactive visualization system for identifying AI-based clusters and similar companies.
We propose a heuristic approach to modeling investor behavior by simulating combinations of simpler systematic investment strategies associated with well-known behavioral biases—in functional forms motivated by an extensive review of the behavioral finance literature—using parameters calibrated from historical data. We compute the investment performance of these heuristics individually and in pairwise combinations using both simulated and historical asset-class returns. The mean-reversion or momentum nature of a heuristic can often explain its effect on performance, depending on whether asset returns are consistent with such dynamics. These algorithms show that seemingly irrational investor behavior may, in fact, have been shaped by evolutionary forces and can be effective in certain environments and maladaptive in others.
Despite its success in financial markets and other domains, collective intelligence seems to fall short in many critical contexts, including infrequent but repeated financial crises, political polarization and deadlock, and various forms of bias and discrimination. We propose an evolutionary framework that provides fundamental insights into the role of heterogeneity and feedback loops in contributing to failures of collective intelligence. The framework is based on a binary choice model of behavior that affects fitness; hence, behavior is shaped by evolutionary dynamics and stochastic changes in environmental conditions. We derive collective intelligence as an emergent property of evolution in this framework, and also specify conditions under which it fails. We find that political polarization emerges in stochastic environments with reproductive risks that are correlated across individuals. Bias and discrimination emerge when individuals incorrectly attribute random adverse events to observable features that may have nothing to do with those events. In addition, path dependence and negative feedback in evolution may lead to even stronger biases and levels of discrimination, which are locally evolutionarily stable strategies. These results suggest potential policy interventions to prevent such failures by nudging the “madness of mobs” towards the “wisdom of crowds” through targeted shifts in the environment
Hamilton’s rule [W. D. Hamilton, Am. Nat. 97, 354–356 (1963); W. D. Hamilton,
J. Theor. Biol. 7, 17–52 (1964)] quantifies the central evolutionary ideas of inclusive fitness and kin selection into a simple algebraic relationship. Evidence consistent with Hamilton’s rule is found in many animal species. A drawback of investigating Hamilton’s rule in these species is that one can estimate whether a given behavior is consistent with the rule, but a direct examination of the exact cutoff for altruistic behavior predicted by Hamilton is almost impossible. However, to the degree that economic resources confer survival benefits in modern society, Hamilton’s rule may be applicable to economic decision-making, in which case techniques from experimental economics
offer a way to determine this cutoff. We employ these techniques to examine whether Hamilton’s rule holds in human decision-making, by measuring the dependence between an experimental subject’s maximal willingness to pay for a gift of $50 to be given to someone else and the genetic relatedness of the subject to the gift’s recipient. We find good agreement with the predictions of Hamilton’s rule. Moreover, regression analysis of the willingness to pay versus genetic relatedness, the number of years living in the same residence, age, and sex shows that almost all the variation is explained by genetic relatedness. Similar but weaker results are obtained from hypothetical questions regarding the maximal risk to
We study the relationships between the real-time psychophysiological activity of professional traders, their financial transactions, and market fluctuations. We collected multiple physiological signals such as heart rate, blood volume pulse, and electrodermal activity of 55 traders at a leading global financial institution during their normal working hours over a nfive-day period. Using their physiological measurements, we implemented a novel metric of
trader’s “psychophysiological activation” to capture affect such as excitement, stress and irritation. We find statistically significant relations between traders’ psychophysiological activation levels and such as their financial transactions, market fluctuations, the type of financial products they traded, and their trading experience. We conducted post-measurement interviews with traders who participated in this study to obtain additional insights in the key
factors driving their psychophysiological activation during financial risk processing. Our work illustrates that psychophysiological activation plays a prominent role in financial risk processing for professional traders.
We investigate the impact of information on biopharmaceutical stock prices via an event study encompassing 503,107 news releases from 1,012 companies. We distinguish between pharmaceutical and biotechnology companies, and apply three asset pricing models to estimate their abnormal returns. Acquisition-related news yields the highest positive return, while drug-development setbacks trigger significant negative returns. We also find that biotechnology companies have larger means and standard deviations of abnormal returns, while the abnormal returns of pharmaceutical companies are influenced by more general financial news. To better understand the empirical properties of price movement dynamics, we regress abnormal returns on market capitalization and a sub-industry indicator variable to distinguish biotechnology and pharmaceutical companies, and find that biopharma companies with larger capitalization generally experience lower magnitude of abnormal returns in response to events. Using longer event windows, we show that news related to acquisitions and clinical trials are the sources of potential news leakage. We expect this study to provide valuable insights into how diverse news types affect market perceptions and stock valuations, particularly in the volatile and information-sensitive biopharmaceutical sector, thus aiding stakeholders in making informed investment and strategic decisions.
Following the approval by the FDA of two COVID-19 vaccines, which are administered in two doses three to four weeks apart, we simulate the effects of various vaccine distribution policies on the cumulative number of infections and deaths in the United States in the presence of shocks to the supply of vaccines. Our forecasts suggest that allocating more than 50% of available doses to individuals who have not received their first dose can significantly increase the number of lives saved and significantly reduce the number of COVID-19 infections. We find that a 50% allocation saves on average 33% more lives, and prevents on average 32% more infections relative to a policy that guarantees a second dose within the recommended time frame to all individuals who have already received their first dose. In fact, in the presence of supply shocks, we find that the former policy would save on average 8, 793 lives and prevents on average 607, 100 infections while the latter policy would save on average 6, 609 lives and prevents on average 460, 743 infections.
The opioid epidemic in the U.S. has resulted in significant costs in human lives as well as to the health care system, employers, and insurers. While there is great motivation and urgency to address the opioid crisis, there are currently few non-opioid pain management medications in the development pipeline. The growing regulatory pressures and stigma surrounding opioids have discouraged investments and research in the pain industry. Using estimates from the literature, our simulations show that a portfolio of pharmaceuticals and medical devices for pain treatment and opioid use disorder, diversified and optimized across different development pathways, yields single digit annualized returns. This suggests that active collaboration between the public and private sectors is needed to incentivize investments in pain research.
The case for investing in fusion energy has never been greater, given increasing global energy demand, high annual carbon dioxide output, and technological limitations for wind and solar power. Nevertheless, financing for fusion companies through traditional means has proven challenging. While fusion startups have an unparalleled upside, their high upfront costs, lengthy delay in payoff, and high risk of commercial failure have historically restricted funding interest to a niche set of investors. Drawing on insights from investor interviews and case studies of public–private partnerships, we propose a megafund structure in which a large number of projects are securitized into a single holding company funded through various debt and equity tranches, with first loss capital guarantees from governments and philanthropic partners. The megafund exploits many of the core properties of the fusion industry: the diversity of approaches to engender fusion reactions, the ability to create revenue-generating divestitures in related fields, and the breadth of auxiliary technologies needed to support a functioning power plant. The model expands the pool of available capital by creating tranches with different risk–return tradeoffs and providing a diversified “fusion index” that can be viewed as a long hedge against fossil fuels. Simulations of a fusion megafund demonstrate positive returns on equity (ROE) and low default rates for the capital raised using debt.
We define long shots as investment projects with four features: (1) low probabilities of success; (2) long gestation lags before any cash flows are realized; (3) large required up-front investments; and (4) very large payoffs (relative to initial investment) in the unlikely event of success. Funding long shots is becoming increasingly difficult—even for high-risk investment vehicles like hedge funds and venture funds—despite the fact that some of society’s biggest challenges such as cancer, Alzheimer’s disease, global warming, and fossil-fuel depletion depend critically on the ability to undertake such investments. We investigate the possibility of improving financing for long shots by pooling them into a single portfolio that can be financed via securitized debt, and examine the conditions under which such funding mechanisms are likely to be effective.
We propose a quantitative framework for assessing the financial impact of any form of impact investing, including socially responsible investing (SRI), environmental, social, and governance (ESG) objectives, and other non-financial investment criteria. We derive conditions under which impact investing detracts from, improves on, or is neutral to the performance of traditional mean-variance optimal portfolios, which depends on whether the correlations between the impact factor and unobserved excess returns are negative, positive, or zero, respectively. Using Treynor-Black portfolios to maximize the risk-adjusted returns of impact portfolios, we propose a quantitative measure for the financial reward, or cost, of impact investing compared to passive index benchmarks. We illustrate our approach with applications to biotech venture philanthropy, divesting from “sin” stocks, investing in ESG, and “meme” stock rallies such as GameStop in 2021.