CHAPTER 8

NEUROSCIENTIFIC AND
EVOLUTIONARY
PERSEPCTIVE

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 OUTLINE

This chapter presents some of the important insights

and findings of neuro-economics in a very condensed
fashion. It is divided into four sections:

 Brain basics
 Important insights
 Adaptive markets hypothesis
 Financial crises and limbic system

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There seems to be a deep divide between the theory and practice
of investing as the following table suggests:
In Theory
 Investors have well- defined goals.
 Investors carefully weigh the odds of 
success and failure.
 Investors know how much risk they 
are comfortable with.
 The smarter an investor is, the more 
money he will make.
In Practice
 Investors are not sure about their
goals.
Investors often act impulsively.
The risk tolerance of investors varies
with the market conditions.
Many smart people commit dumb
investment mistakes. For example, Sir
Isaac Newton was financially wiped
out in a stock market crash in 1720.

 People who monitor their  People who pay almost no attention

investments closely tend to make to their investments tend to do
more money. better.
 Greater effort leads to superior  On average, professional investors do
performance. not outperform amateur investors.

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• Neurofinance combines neuroscience with
strategies to decode decision-making
patterns and read the story in financial
statements.
• Put in the simplest terms possible,
neurofinance is using brain science to drive
decisions, growth and profits. 

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In addition to explaining individual and market
behavior as a function of classic financial
variables, it aims to explain how neural and
physiological signals relate and give rise to
individual differences in financial decision
making.
Neurofinance incorporates noninvasive measures
of neural and physiological activity.

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NEUROFINANCE PARTIALLY INCORPORATES
BEHAVIORAL FINANCE BUT ADDS TWO MAJOR GOALS:

(A) ELUCIDATING THE BIOLOGICAL (NEURAL AND

PHYSIOLOGICAL) MECHANISMS OF BEHAVIORS OF
FINANCIAL MARKET PARTICIPANTS (TSENG, 2006);

(B) PROVIDING A PHYSIOLOGICALLY MOTIVATED,

ALTERNATIVE EXPLANATION FOR THE APPARENT
FAILURE OF STANDARD FINANCE THEORIES.

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• The founding principles of neuroeconomics are that the
behavioral deviations observed when financial decisions are
made have a relevant explanation, and that this explanation
involves brain mechanisms.
• Neuroeconomics is based on the theory that explaining these
mechanisms will lead to a better understanding of the internal
factors of irrationality and will contribute to improvements in
understanding financial decision-making.
• It could, therefore, be applied to designing better and more
accurate financial modeling.

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What causes this divide?
Neuroeconomics, a new- born discipline, helps in
explaining this divide. A hybrid of neuroscience, economics,
and psychology, neuroeconomics seeks to understand what
drives investment behaviour, not only at a theoretical and
practical level, but also at a biological level.

It provides an understanding of the important

neurophysiological foundations underlying a variety of
cognitive processes and behaviours.

Neuroeconomics seeks to model what goes on inside an

individual’s mind just as organisational economics models
what goes on inside a firm.
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 Centre for Financial Management , Bangalore
• Recent studies that tie neurology and finance together explain why the human mind is
susceptible to irrationality. Rather than analyzing financial behavior in the context of
psychology, researchers have taken a more scientific approach by monitoring activity
within the brain about the driving forces when making investment decisions.
Examining how we process and respond to financial information gives insight into
how investors can improve their decision-making. 
• https://streetfins.com/intro-to-neurofinance/

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 Centre for Financial Management , Bangalore
 ADAPTIVE MARKETS HYPOTHESIS

• According to modern research, emotions are central to

rationality. As Andrew Lo put it, “Emotions are the basis for a
reward and punishment system that facilitates the selection of
advantageous behaviour, providing a kind of mental yardstick
for animals to measure the costs and benefits of the various
actions open to them.”
• According to Andrew Lo, the neuroscientific perspective
suggests an alternative to EMH which he calls the Adaptive
Market Hypothesis (AMH). The essence of AMH is that the
interaction between market forces and preferences results in a
much more dynamic economy, which is driven by competition,
natural selection, and diverse individual and institutional
behaviour.

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AMH argues that people are motivated by their own self-interests, make
mistakes, and tend to adapt and learn from them

Adaptive market hypothesis (AMH) considers both these conflicting views

as a means of explaining investor and market behavior. It contends that
rationality and irrationality coexist, applying the principles of evolution and
behavior to financial interactions.

The adaptive market hypothesis (AMH) is based on the following basic

tenets:
People are motivated by their own self-interests
They naturally make mistakes
They adapt and learn from these mistakes

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Eg: One of them referred to an investor buying near the top of a bubble
because he or she first developed portfolio management skills during an
extended bull market. Lo described this as “maladaptive behavior”,
arguing that the reasons for doing this might appear compelling, even if
it is not the best strategy to execute in that particular environment.

During the housing bubble, people leveraged up and purchased assets,

assuming that price mean reversion wasn't a possibility because it
hadn't occurred recently. Eventually, the cycle turned, the bubble burst
and prices fell.

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The main idea behind the adaptive markets hypothesis is that financial
markets are governed more by the laws of biology than by the laws of physics.
There are five basic tenets of adaptive markets.

The AMH applies the framework of evolutionary biology to specific financial

contexts. If you follow that perspective to its logical conclusions for any given
issue in finance, you’ll get answers that are quite different than what you’d get
from either an efficient markets hypothesis (EMH) or [a] behavioral finance
perspective.

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The EMH says that prices fully reflect all available information, so there’s no
use trying to pick winners or losers or timing the market. You should just
consider your own risk preferences, your age, your income, and the kind of
retirement you’d like to have and then formulate your asset allocation to
stocks and bonds to maximize your chances of achieving these goals.

The AMH starts with the observation that there’s no guaranteed return on
equities or bonds. Their performance depends on particular market
conditions, and those conditions evolve over time. In other words, there are
periods when equities will do well, and there are periods when equities won’t
do well. So if your goal is to retire with a particular level of wealth, you need
to manage your asset allocation dynamically. When equity markets have a
higher expected return, you’ll want to tilt more toward equity markets; when
equity markets have a lower expected return, you’ll tilt more toward bonds.

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• According to Andrew Lo, the principal architect of the AMH, “The
primary components of the AMH consist of the following ideas.
(A1) Individuals act in their own self-interest.
(A2) Individuals make mistakes.
(A3) Individuals learn and adapt.
(A4) Competition drives adaptation and innovation.
(A5) Natural selection shapes market ecology.
(A6) Evolution determines market dynamics.”
• The bottom line in the AMH is survival and innovation is the key to
survival. As Andrew Lo put it: “The AMH has a clear implication for
all financial market participants: survival is ultimately the only
objective that matters. While profit maximization, utility
maximization, and general equilibrium are certainly relevant
aspects of market ecology, the organizing principle in determining
the evolution of markets and financial technology is simply
survival.”

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