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Variety Is the Spice of Life: Irrational Behavior as Adaptation to Stochastic Environments

Thomas J. Brennan (), Andrew W. Lo and Ruixun Zhang ()
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Thomas J. Brennan: Harvard Law School, Cambridge, MA, USA
Andrew W. Lo: MIT Sloan School of Management, MIT Laboratory for Financial Engineering, MIT Computer Science and Artificial Intelligence Laboratory, Cambridge, MA 02142–1347, USA
Ruixun Zhang: MIT Laboratory for Financial Engineering, Cambridge, MA, USA

Quarterly Journal of Finance (QJF), 2018, vol. 08, issue 03, 1-39

Abstract: The debate between rational models of behavior and their systematic deviations, often referred to as “irrational behavior”, has attracted an enormous amount of research. Here, we reconcile the debate by proposing an evolutionary explanation for irrational behavior. In the context of a simple binary choice model, we show that irrational behaviors are necessary for evolution in stochastic environments. Furthermore, there is an optimal degree of irrationality in the population depending on the degree of environmental randomness. In this process, mutation provides the important link between rational and irrational behaviors, and hence the variety in evolution. Our results yield widespread implications for financial markets, corporate behavior, and disciplines beyond finance.

Keywords: Behavioral bias; behavioral finance; adaptive markets hypothesis; evolutionary game theory (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1142/S201013921850009X

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