Evolutionary models of financial markets.

Levin and Lo's introduction of a PNAS special issue on evolutionary models of financial markets is an interesting read. A few clips:

The brilliant evolutionary insights of Darwin and others have revolutionized our understanding of the world. Darwin was impressed by the “tangled bank” of elaborate forms that emerged from the undirected processes of evolution to produce the complexity of the biological world. Through continuous innovation coupled with the deceptively simple filter known as natural selection, the characteristics of species and their interactions change in response to changing environments. However, evolution is not limited only to the biological world. Wherever the evolutionary forces of reproduction, variation, and selection exist—as they do in financial markets—evolutionary consequences will follow. There are of course major differences as well between the nature of the evolutionary process in ecological and economic contexts, largely influenced by the relative importance of top-down control, and the degree to which predictive models and long-term planning can be invoked. These are, however, differences of degree.

There are profound similarities between financial systems and the biosphere. Both are complex adaptive systems in which individual agents act to enhance their own interests and objectives, leading to self-organization and emergent features. In viewing global financial markets as comprising a complex-adaptive biological system, researchers in this area intend to develop more effective models to understand these systems. This is not only of theoretical interest, but also has the practical aim to promote economic growth while maintaining financial stability, with the ultimate goal of allocating resources more efficiently through better financial methods.

Evolution is about short-term, relative optimality with respect to other participants in the system. In the biosphere, natural selection acts to improve reproductive success relative to the benchmark of other genomes, within and across species. Evolutionary change can thus be thought of in terms of differential fitness: that is, small differences in reproductive rates between individuals over time leading to large differences in populations. Even the very mechanisms of evolution—including those that generate new variation—are subject to constant modification. In the financial world, the evolutionary forces of mutation, recombination, reproduction, and selection often work on financial institutions and market participants through direct competition, finance “red in tooth and claw.” Financial concepts and strategies thus reproduce themselves through cultural transmission and adoption based on their success in the marketplace. These strategies undergo variation through financial innovation, analogous to mutation or genetic recombination in a biological system, but take place at the level of information and abstract thought in financial contexts. It is “survival of the richest.”

The evolutionary lens provides a natural way to introduce biological concepts into financial and economic analysis. As the evolutionary biologist Theodosius Dobzhansky said, “Nothing in biology makes sense except in the light of evolution” (5). The same may hold for the financial world. Phenomena that have been difficult to analyze within a traditional economic framework, such as growth, size, scale, self-organization, the lifecycle of products and industries, bull/bear market cycles, and the rate of variation or innovation within a system, are all subject to evolutionary forces, whether they take place in the Petri dish or on the trading floor. Biological experiments thus may be able to directly inform economic insights, and market behavior may be able to shed light on evolutionary mysteries in the biological world.