The the literature of the cognitive neurosciences.

The
battle between the proponents of the EMH and champions of behavioural fiancé
has been studied for years, to get additional insights we refer to the
literature of the cognitive neurosciences. This research led to a significant
reformulation of psychological models of decision making; which involved
research tools such as positron emission tomography (PET) and functional
magnetic resonance imaging (MRI) (Lo, 2005), where an array of images of the
subject’s brain was captured in real time as questions were being asked. The
results were determined and interpreted by the detecting the amount of blood
flow in certain areas of the brain, before, during and after the task The
activation in certain parts of the brain were linked to the performance of the
task.

One
major discovery was that there is an apparent link between rational behaviour
and emotion; which shed light on financial decision-making. How? Damasio (1994)
discovered that the ability of patents who had underdone surgical removal of
brain tumours, to make rational choices suffered. A patient, code-named Elliot,
experienced a profound effect on his day-to-day activities after his emotional
faculties were removed from his brain. Damasio (1994) noticed that his flow of
work at a point in time stopped, focusing on something else that was
captivating. It was as though Elliot had become irrational concerning the
larger frame of behaviour in his daily decision.

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Is
the source of irrationality, emotion? Behaviour can be viewed as the observable
indication of interactions among several components of the brain, sometimes
competitively and others cooperatively. Nevertheless, under other
circumstances, emotional responses can overrule more complex deliberations,
neuroscientists have shown that emotion is the first response in the sense that
individuals exhibit emotional reactions to objects and events far quicker than they
can articulate what those objects and events are (Zajonc, 1980).

As
environmental conditions change, so does the relative importance of each
component of the brain, individuals are able to adapt to new situations by
learning and implementing more advantageous behaviour and this is often
accomplished by several components of the brain acting together. As a result
what economists call ‘preferences’ are often complicated interactions among
subcomponents within each of the three parts of the brain; this perspective
implies that preferences may not be stable through time, but are likely to be
shaped by a number of factors, both internal and external to the individual,
i.e., factors related to the individual’s personality, and factors related to
specific environmental conditions in which the individual is currently
situated. This neuroscientific perspective suggests an alternative to the EMH,
one in which market forces and preferences interrelate to yield a much more
dynamic economy, one driven by competition, natural selection, and the
diversity of individual and institutional behaviour. This is the essence of the
Adaptive Markets Hypothesis.

?. The Adaptive Market Hypothesis

A
promising path is to view financial markets from a biological aspect and
specifically within an evolutionary framework in which market instruments,
institutions and investors interact and evolve dynamically according to the law
of economic selection. Under this perspective financial agents compete and
adapt, but do not necessarily do so in an optimal fashion.

This
evolutionary approach was grossly influenced by recent advances in the emerging
discipline of evolutionary psychology, which built on research of Wilson (1975)
in applying the principles of competition, reproduction and natural selection
to social interaction, yielding convincing justification for certain kinds of
human behaviours, such as altruism, kin-selection and religion. It is due to ‘Socio-biology’
(Wilson, 1975), we can entirely reconcile the EMH with all of its behavioural
alternatives, leading to a new creation; the Adaptive Market Hypothesis (AMH). These
ideas have been exported to a number of economic and financial studies and at
least two conspicuous practitioners have proposed Darwinian alternatives to the
EMH: in a chapter titled ‘The zoology of markets’, Niedernoffer (1997) compares
financial markets to an ecosystem with dealers as ‘herbivores, speculators as
‘carnivores’ and floor traders and distressed investors as ‘decomposers’. The
notion of equilibrium which is central to the EMH is namely realised in
practice and that market dynamics are better explained by evolutionary
processes.

This
evolutionary perspective makes more modest claims, viewing individuals as
organisms that have been enhanced through a generation of natural selection
(Dawkins, 2016), which ensures the survival of their genetics. This perspective
implies that behaviour is not really intrinsic and exogenous, but evolves by
natural selection and depends on the particular environmental through which
selection occurs. That is, natural selection operates not only upon genetic
material but also upon social and cultural norms in Homo sapiens; hence
Wilson’s term ‘socio-biology’. To make this practical in an economics context,
Lo (2004) re-examines the idea of ‘bounded rationality’, first spoken by Simon
(1982), who suggested that individuals are hardly capable of the kind of
optimization that neoclassical economics calls for in the standard theory of
consumer choice. As an alternative, he argued that, because optimization is pricey
and humans are naturally limited in their computational capabilities, they
engage in something he called ‘satisficing’, an alternative to optimization in
which individuals make choices that are merely satisfactory, not necessarily
optimal. In other words, individuals are bounded in their degree of
rationality.

However
what determines the point at which an individual stops optimizing and reaches a
satisfactory solution? (Lo, 2005) argues that an evolutionary perspective
provides the missing ingredient in Simon’s framework; to properly answer the
question, such points are not determined analytically but through trial and
error and also natural selection. As mentioned earlier in this essay, people
make their choices based on past experiences and their ‘best guess’ as to what
might be optimal and they learn by receiving positive or negative reinforcement
from the outcomes; if these reinforcements aren’t in place, they do not learn.
To resolve this, individuals develop heuristics to solve various economic
challenges, if these challenges remain stable, the heuristics will eventually
adapt to yield just about. If however, the environment changes, then it means
that the heuristics of the old environment are not suited to the new
environment.

Compared
to the EMH, the AMH provides profound information that helps understand how
individuals behave in the face of financial decisions, it can be viewed as a
new version of the EMH, and the primary components of the AMH (Lo, 2005) shows
this reasoning and  are as follows:

§  A1: Individuals act in their own
self-interest: what constitutes self-interest is not
defined by the AMH nor does self-interest correspond to rationality. The EMH
and the AMH have a common starting point at A1 but the two paradigms part
company with A2 and A3.

§  A2: Individuals make mistakes: In
efficient markets, investors do not make mistakes, and there is not any learning
and adaptation because the market environment is stationary and always in
equilibrium.

 

§  A3: Individuals learn and adapt: In
the AMH framework, mistakes occur often, but individuals are capable of
learning from mistakes and adapting their behaviour accordingly.

§  A4: Competition drives application
and innovation: This suggests that adaptation does not
occur freely of market forces, but is driven by competition, i.e., the push for
survival; the survival of the richest, in this context.

§  A5: Natural selection shapes market
ecology: This implies that the existing market environment is
a product of this selection process.

A6: Evolution determines market dynamics: This states that the
sum total of these components; selfish individuals, competition, adaptation, natural
selection, and environmental conditions