Andrew Lo, a financial engineer at MIT, is well known for his ‘Adaptive Markets Hypothesis.’ Lo’s perspective is that understanding human irrationality in markets might require evolutionary thinking. From a traditional economic perspective (the ‘Efficient Markets Hypothesis’), irrationality in market participant behavior should create opportunities for savvy speculators to exploit, and as more people exploit those opportunities, irrational behavior should vanish from the marketplace as those irrational players get wiped out. But are market forces strong enough to overcome irrational behavioral biases? Apparently not!
I think the ‘adaptive markets hypothesis’ is not that compelling because it’s not in itself a falsifiable hypothesis. It only suggests that evolutionary theory might have use in understanding why markets operate away from an equilibrium in which market prices reflect all the information available to participants. In other words, “people make bad decisions despite having good information…because evolution”.
It’s an interesting jumping off point though. Lo and his co-authors have constructed a simple evolutionary model in which a population evolves “irrational” risk-aversion biases in response to systemic risk. The intuition is that many “irrational” behavioral biases might have been adaptive over long periods of time, but are maladaptive in the short-term when it comes to making money. In short, since continued survival is the only objective that really matters in evolution and financial markets (unless there are government bailouts!), at least some decision-making biases (risk aversion) might arise over evolutionary time. As Lo notes in the PNAS paper, this kind of model could be tested using microbial experimental evolution!
In my mind, it could be that evolution by natural selection has shaped human cognition to have certain cognitive biases. For instance, life might be less stressful for an optimist compared to someone who clearly sees the futility of his or her actions. Alternatively, perhaps certain cognitive biases are associated with other positive traits. People instinctively judge power and rank in social groups, and it is often important to do so accurately. A side-effect of this important trait is that messages from powerful or well-known people carry more weight: a lesson that advertisers understand very well. Maybe in some cases natural selection favors people who make risky decisions, because some risky decisions occasionally result in rare but extremely large payoffs (e.g. becoming a successful artist, musician, or athlete). It could also be that prudent decision-making confers a negligible genetic advantage over people who tend to make risky or poor choices. People have limited time, energy, money, and memory to dedicate to decision-making, and perhaps the short-term benefits of excellent decision-making (making the best out of environmental fluctuations over one lifetime) wash out over longer evolutionary timescales (it doesn’t matter if you make great decisions compared to somebody else if a plague wipes out all your descendants a thousand years from now). In the worst case, making good decisions might simply be impossible, say if the environment changes so rapidly that the best news is always out-of-date. For example, the modern financial system is so complex and fast-changing that regulators don't have a chance.
People are *pretty good* at making decisions, but they clearly fail a lot of the time. Understanding why is going to be a productive area of research for a long time.