Market Efficiency, Decision Processes, and Evolutionary Games

This paper explores ramifications of quasirational behavior in capital markets. Despite the academic literature asserting that financial markets are efficient and humans are rational agents, there is a widespread discontentment among practitioners and a growing body of researchers that neither of those premises is valid. The increasing amount of empirical evidence against perfectly efficient capital market processes has been examined in great depth. However, academic research is just beginning to explore the causes of that imperfect rationality. A diverse group of fields has taken a keen interest in how humans make decisions. The foundation of this paper uses methods drawn from such disparate disciplines as cognitive psychology and philosophy, biology, genetics, economics, computer science, and game theory. Human decision processes in making investment decisions have a fundamental impact on capital market processes. Thus, many of the previously unexplained phenomena of the capital markets may arise from ways in which human decision processes depart from perfect rationality. This paper addresses the concept of an equilibrium using the tools of evolutionary game theory. Evolutionary game theory was developed originally to explain the behavior of animals in confrontational environments. Here, evolution and animal behavior are paradigms for human quasirationality. The primary benefit of this evolutionary treatment is that it avoids the demands of superrationality in classical game theory. These allowances for quasirationality make it ideally suited for analysis of capital markets and adaptive human economic behavior. This paper begins by outlining the behavioral case against market efficiency, then describes human decision processes in an economic context. Evolutionary game theory is introduced next. A good portion of the paper concerns the equilibrium concept used in evolutionary games: the evolutionarily stable strategy (ESS). The remainder of the paper discusses the properties of the ESS both within generations (the static ESS) and across generations (the dynamic ESS). The paper concludes by relating the ESS perspective to developing a capital market theory that recognizes the quasirationality inherent in modern capital markets.