We examine the contagion of investment ideas in a multiperiod setting in which investors are more likely to transmit their ideas to other investors after experiencing higher payoffs in one of two investment styles with different return distributions. We show that heterogeneous investment styles are able to coexist in the long run, implying a greater diversity than predicted by traditional theory. We characterize the survival and popularity of styles in relation to the distribution of security returns. In addition, we demonstrate that psychological effects such as conformist preference can lead to oscillations and bubbles in the choice of style. These results remain robust under a wide class of replication rules and endogenous returns. They offer empirically testable predictions, and provide new insights into the persistence of the wide range of investment strategies used by individual investors, hedge funds, and other professional portfolio managers.

We propose a Markov chain Monte Carlo (MCMC) algorithm for estimating the parameters of algorithmic models of investor behavior. We show
that this method can successfully infer the relative importance of each heuristic among a large cross-section of investors, even when the number of observations per investor is quite small. We also compare the accuracy of the MCMC approach to regression analysis in predicting the relative importance of heuristics at the individual and aggregate levels and conclude that MCMC predicts aggregate weights more accurately while regression outperforms in predicting individual weights.

How does a firm’s market power in existing products affect its incentives to innovate? We explore this fundamental question using granular project-level and firm-level data from the pharmaceutical industry, focusing on a particular mechanism through which incumbent firms maintain their market power: “reverse payment” or “pay-for-delay” agreements to delay the market entry of competitors. We first show that when firms are unfettered in their use of “pay-for-delay” agreements, they reduce their innovation activities in response to the potential entry of direct competitors. We then examine a legal ruling that subjected these agreements to antitrust litigation, thereby reducing the incentive to enter them. After the ruling, incumbent firms increased their net innovation activities in response to competitive entry. These effects center on firms with products that are more directly affected by competition. However, at the product therapeutic area level, we find a reduction in innovation by new entrants after the ruling in response to increased competition. Overall, these results are consistent with firms having reduced incentives to innovate when they are able to maintain their market power, highlighting a specific channel through which this occurs.

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 her own life that the subject is willing to take in order to save the recipient’s life.

Using a novel dataset of 653,455 individual brokerage accounts belonging to 298,556 households, we document the frequency, timing, and duration of panic sales, which we define as a decline of 90% of a household account’s equity assets over the course of one month, of which 50% or more is due to trades. We find that a disproportionate number of households make panic sales when there are sharp market downturns, a phenomenon we call ‘freaking out.’ We show that panic selling and freak-outs are predictable and fundamentally different from other well-known behavioral patterns such as overtrading or the disposition effect.

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

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.

The 75th anniversary of the founding of the Financial Analysts Journal offers a rare vista of the evolutionary path of financial analysis and its practitioners. That path is by no means random but is shaped by a complex ecosystem in which technological innovation interacts with shifting business conditions and a growing population of financial stakeholders. Using the lens of the Adaptive Markets Hypothesis—the principles of evolutionary biology and ecology applied to the financial system—we can clearly identify eight discrete financial “eras” in which unique combinations of economic need and technological advances gave rise to new products, services, and financial institutions. By understanding the underlying drivers and resulting dynamics of these eras, we can begin to develop a deeper appreciation for the origins of financial innovation and its great promise for our future.

Bayes' rule is a fundamental principle that has been applied across multiple disciplines. However, few studies have addressed its origin as a cognitive strategy or the underlying basis for generalization from a small sample. Using a simple binary choice model subject to natural selection, we derive Bayesian inference as an adaptive behavior under certain stochastic environments. Such behavior emerges purely through the forces of evolution, despite the fact that our population consists of mindless individuals without any ability to reason, act strategically, or accurately encode or infer environmental states probabilistically. In addition, three specific environments favor the emergence of finite memory—those that are Markov, nonstationary, and environments where sampling contains too little or too much information about local conditions. These results provide an explanation for several known phenomena in human cognition, including deviations from the optimal Bayesian strategy and finite memory beyond resource constraints.

Probability matching, also known as the “matching law” or Herrnstein’s Law, has long puzzled economists and psychologists because of its apparent inconsistency with basic self-interest. We conduct an experiment with real monetary payoffs in which each participant plays a computer game to guess the outcome of a binary lottery. In addition to finding strong evidence for probability matching, we document different tendencies towards randomization in different payoff environments—as predicted by models of the evolutionary origin of probability matching—after controlling for a wide range of demographic and socioeconomic variables. We also find several individual differences in the tendency to maximize or randomize, correlated with wealth and other socioeconomic factors. In particular, subjects who have taken probability and statistics classes and those who self-reported finding a pattern in the game are found to have randomized more, contrary to the common wisdom that those with better understanding of probabilistic reasoning are more likely to be rational economic maximizers. Our results provide experimental evidence that individuals—even those with experience in probability and investing—engage in randomized behavior and probability matching, underscoring the role of the environment as a driver of behavioral anomalies.

This special issue of PNAS is intended to highlight this relatively new interdisciplinary field, featuring original joint research from collaborating biologists and financial economists on the interplay between evolutionary theory and market dynamics. The aim of this research is not to debunk traditional financial theories, but rather to complement existing research and attempt to reconcile the apparent gap between theoretical ideals and empirical realities. Given that financial economics is based so heavily on empirical observation, the synergies with evolutionary theory—which emerged from Charles Darwin’s careful study of Galápagos flora and fauna and other studies—run deep. This program is intended to improve our models rather than simply assume away or ignore the apparent inefficiencies and irrationality contained in financial data. The application of principles and techniques from evolutionary biology and associated disciplines, like ethology and ecology, may provide a key to unlocking long-standing puzzles within these disciplines. Our goal in publishing this special issue is to disseminate these ideas to a broader audience, and to encourage greater collaboration among ecologists, economists, evolutionary biologists, regulators, and finance professionals.

We construct an evolutionary model of a population consisting of two types of interacting individuals that reproduce under random environmental conditions. We show that not only does the evolutionarily dominant behavior maximize the number of offspring of each type, it also minimizes the correlation between the number of offspring of each type, driving it toward −1. We provide several examples that illustrate how correlation can be used to explain the evolution of cooperation.

We use a global survey of over 22,400 individual investors, 4,892 financial advisors, and 2,060 institutional investors between 2015 and 2017 to elicit their asset allocation behavior and risk preferences. We find substantially different behaviors among these three groups of market participants. Most institutional investors exhibit highly contrarian reactions to past returns in their equity allocations. Financial advisors are also mostly contrarian; a few of them demonstrate passive behavior. However, individual investors tend to extrapolate past performance. We use a clustering algorithm to partition individuals into five distinct types: passive investors, risk avoiders, extrapolators, contrarians, and optimistic investors. Across demographic categories, older investors tend to be more passive and risk averse.

One of the most enduring empirical regularities in equity markets is the inverse relationship between stock prices and volatility. Also known as the “leverage effect”, this relationship was first documented by Black (1976), who attributed it to the effects of financial or operating leverage. This paper documents that firms which had no debt (and thus no financial leverage) from January 1973 to December 2017 exhibit Black’s leverage effect. Moreover, it finds that the leverage effect of firms in this sample is not driven by operating leverage. On the contrary, in this sample the leverage effect is stronger for firms with low operating leverage as compared to those with high operating leverage. Interestingly, the firms with no debt from the lowest quintile of operating leverage exhibit the leverage effect that is on par with or stronger than that of debt-financed firms.