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

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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)

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.

Suggested Citation

  • Thomas J. Brennan & Andrew W. Lo & Ruixun Zhang, 2018. "Variety Is the Spice of Life: Irrational Behavior as Adaptation to Stochastic Environments," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 8(03), pages 1-39, September.
  • Handle: RePEc:wsi:qjfxxx:v:08:y:2018:i:03:n:s201013921850009x
    DOI: 10.1142/S201013921850009X
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