Unit 5 Part 1

15.
481x Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Unit 5: Evolution and the Origin of Behavior
Lecture: Principles of Evolution
Roadmap
Efficient Markets Behavioral Finance
Rational Expectations Psychology
Evolutionary Biology Cognitive Neurosciences

Ecology
Artificial Intelligence Adaptive Markets

Bounded Rationality Hypothesis
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Today’s Readings
© 2020 by Andrew W. Lo
Lecture 5 Slide 3
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Insights From Neuroscience
§ Behavior is produced by multiple neural components
– Limbic system (pain/fear, pleasure/greed, fight-or-flight response), neocortex
(logical deliberation, planning, hypothesis generation, abstract thought), and
memory
§ Components play multiple roles (physical vs. social pain)
– Developing single-purpose components is physiologically and developmentally
“expensive”; economy of biology
§ Homo economicus arises from proper balance of these
components; irrational behavior arises from improper balance
– How is “proper” and “improper” determined?
Lecture 5 Slide 4
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Lecture 5 Slide 5
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Adaptive Behavior
Modern Sharks Appeared 100m Years Ago
§ Great white appeared 16m years ago
§ Travel at 50kph, 300 teeth in 7 rows, can smell one drop of
blood in 10b, day/night vision with protection, can sense EM
fields (gps), can detect vibrations 250 meters away, bite force of
1.8 tons psi, camouflaged
§ Generation length of 23 years Þ 695,652 generations so far
§ Many opportunities to adapt to its environment Þ likely to be
extremely well-adapted
Lecture 5 Slide 6
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Adaptive Behavior
Lecture 5 Slide 7
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The Environment Matters
Chicxulub Impactor and Volcano: 65,000,000 years ago
Lecture 5 Slide 8
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Outline
§ Basic principles of evolution
§ Human evolution
§ Behavior and genetics
§ Sociobiology and evolutionary psychology
Lecture 5 Slide 9
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Basic Principles of
Evolution
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A Primer On Evolution
§ “Evolution is the process of elimination”, E. Mayr
§ “90% of success is just showing up,” W. Allen
§ Three components of evolution: (1) diversity of traits; (2)
selection of traits; (3) heredity of traits
§ What is a trait? Þ Depends on selection!
– Height, weight, speed, strength, pigmentation,…, behavior,
intelligence
§ Sexual reproduction speeds up evolution
§ Mutation introduces diversity
Lecture 5 Slide 11
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§ Example: white peppered moth
§ Before industrial Revolution, white version common

§ During Industrial Revolution, black version dominated
§ White version now dominates
Lecture 5 Slide 12
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At What Level Does Selection Operate?
§ According to Dawkins, at the genetic level!
§ Genes replicate, hence more successful replication
will be more represented
§ Organisms are merely conduits of genes
§ Extension of Darwin’s original theory
§ Explains altruism, cooperation, etc.
– Concept of “inclusive fitness”
– Attempts to explain cultural evolution (memetics)
Lecture 5 Slide 13
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The Power of Selection
How Easy Is It To Beat The Market?
§ Consider m portfolio managers
§ Must control for risk:
§ Assume b = 1 or risk taken into account

§ Define time t performance indicator kit
Lecture 5 Slide 14
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§ Consider t = 1,…,T periods
§ Define overall performance indicator ki
§ Null Hypothesis H: no superior performance:
Lecture 5 Slide 15
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§ Probability of T successes in T trials:
§ Probability of k successes in T trials:
Lecture 5 Slide 16
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§ Probability of k successes in T trials for “most successful” manager:
Experimental Evidence
1 2 3 4 5 6 7
8 9 10 11 12 13 Total
§ But what about hereditary transmission of this “trait”?

§ Without transmission, selection produces only “noise”
Lecture 5 Slide 17
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§ Different behavior for k* than ki (why?)
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Lecture 5 Slide 19
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Lecture 5 Slide 20
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Lecture 5 Slide 21
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§ Probability of k successes in T trials for “most successful”
manager:
§ For “most successful” fund, 11/13 is average!

§ When m = 500, Prob(12/13 or better) > 50%!
§ Does this imply no performance ability among managers?
§ NO: false positives doesn’t mean everything is negative
Lecture 5 Slide 22
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Some Evolutionary Arithmetic
How Powerful Are Evolutionary Forces?
§ Consider drawing 9 random letters
§ How likely is “CAPMLIVES”?
§ 1 Out of 269 = 5,429,503,678,976
§ Suppose initial draw is: “TJIXOMSFZ”
§ How long before “CAPMLIVES”?
Lecture 5 Slide 23
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Suppose 10 “Offspring” Are Produced:
§ For each offspring:
– Each letter unchanged with prob 99/100
– Changed with prob 1/100 to another letter
– If changed, 25 equally likely possibilities
§ “Best” offspring is the parent of the next 10 offspring
– “Best” means closest match (fittest)
– In case of ties, randomize
Lecture 5 Slide 24
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Probability of At Least 1 Child With At Least 1 Match:
P(incorrect letter ® correct letter) = 1/100 ´ 1/25 = 0.0004
P(all letters remain incorrect in 10 copies) = (1 - 0.0004) 9´10
= 0.9646
P(at least 1 match) = 1 - 0.9646 = 0.0354
Generations Before At Least 1 Match:
1/0.0354 = 28
Lecture 5 Slide 25
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How Many Generations From 0 to 9 Correct?
§ Add 0 ® 1, 1 ® 2, … , 8 ® 9
§ Approximately 751 Generations
§ Not bad, for “trial and error”
§ Evolutionary forces (selection) can be substantial!
Lecture 5 Slide 26
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TJIXOMSFZ TQHXOMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPVLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFZ TQHXOMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPVLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFZ TQHXXMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPVLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFZ TQHXXMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFZ TQHXXMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDMRQS LQPXZCRI S CGPXZZVES CRPMLZVES CBPMLCVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDMRQS LGPXZCPI S CGPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDMRQS LGPXZCPI S CGPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRQS LGPXZCPI S CGPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRQS LGPXZCPI S CGPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRQS LGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CGPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRQS CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJIXOMSFS TQHXXMRQS LQHXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQHXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQHXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQAXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQAXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLNVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQAXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLWVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQAXDXRI S CGPXZCPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLWVES CBPMLWVES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXXMRQS LQAXDXRI S CGPXZZPI S CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXDMRQS LQAXDXRI S CGPXZZPES CRPXZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXDMRQS LQAXDXRI S CGPXZZVES CRPVZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXDMRQS LQAXDXRI S CGPXZZVES CRPVZZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLMVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
925
TJHXOMRFS TQHXDMRQS LQAXDXRI S CGPXZZVES CRPVLZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLMVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TJHXOMRFS TQHXDMRQS LQAXDXRI S CGPXZZVES CRPVLZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TQHXOMRFS TQHXDMRQS LQPXZXRI S CGPXZZVES CRPVLZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CYPMLI VES
TQHXOMRFS TQHXDMRQS LQPXZXRI S CGPXZZVES CRPVLZVES CRPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES CAPMLI VES
TQHXOMRFS TQHXDMRQS LQPXZXRI S CGPXZZVES CRPVLZVES CBPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TQHXOMRGS TQHXDMRQS LQPXZXRI S CGPXZZVES CRPVLZVES CBPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
TQHXOMRGS TQHXDMRQS LQPXZCRI S CGPXZZVES CRPVLZVES CBPMLZVES CBPMLLVES CBPMLLVES CBPMLMVES CBPMLPVES CBPMLWVES CBPMLI VES CBPMLI VES CGPMLI VES CGPMLI VES
Human Evolution
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Human Evolution
Lecture 5 Slide 29
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Human Evolution
Human
Chimpanzee
Source: Tattersall (2008)
Lecture 5 Slide 30
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Human Evolution
A. afarensis A. africanus P. aethiopicus P. boisei P. robustus
H. habilis H. rudolfensis H. ergaster H. erectus H. heidelbergensis
H. rhodesiensis H. neanderthalensis H. sapiens
Source: http://unlobogris.deviantart.com/art/Hominidae-panoply-46191663
Lecture 5 Slide 31
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Human Evolution
Source: Tattersall (2008)
Lecture 5 Slide 32
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Human Evolution
Mode 2 Hand Axe and Cleaver Cro-Magnon Blade Tools

1.5mya 43kya
Lecture 5 Slide 33
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Human Evolution
A Puzzle In The Fossil Record
§ Anatomically modern humans 200,000 years ago
§ Symbolically complex artifacts only 80,000 years ago
§ Gaps in the record? But more complex over time
Earliest known artwork: Blombos Cave,

South Africa. Ochre was scraped flat
and carved into triangular designs.
Dated 77 kya bp. Henshilwood (2002)
Lecture 5 Slide 34
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Human Evolution
A Puzzle In The Fossil Record
§ Tattersall’s “Symbolic Revolution”
§ Existing brain potential unlocked by cultural stimulus
– Intentionality: understanding complex motives
– Language: communicating symbolic thought
§ Rapid “fine-tuning” of abilities via natural selection
§ Cognitive explosion!
Lecture 5 Slide 35
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Evolution Is Not Always Beneficial
PNAS
Jan 21, 2014
Lecture 5 Slide 36
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Evolution Is Not Always Beneficial
Source Isabelle De Groote/ Natural History Museum

Lecture 5 Slide 37
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15.

481x Financial Market Dynamics

Evolutionary Biology Cognitive Neurosciences

Artificial Intelligence Adaptive Markets

§ Before industrial Revolution, white version common

§ Assume b = 1 or risk taken into account

§ Probability of k successes in T trials:

§ But what about hereditary transmission of this “trait”?

§ Different behavior for k* than ki (why?)

§ For “most successful” fund, 11/13 is average!

Generations Before At Least 1 Match:

Source: Tattersall (2008)

A. afarensis A. africanus P. aethiopicus P. boisei P. robustus

H. habilis H. rudolfensis H. ergaster H. erectus H. heidelbergensis

H. rhodesiensis H. neanderthalensis H. sapiens

Source: Tattersall (2008)

Mode 2 Hand Axe and Cleaver Cro-Magnon Blade Tools

Earliest known artwork: Blombos Cave,

Source Isabelle De Groote/ Natural History Museum

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