From standard to evolutionary finance: a literature survey

Abstract

The traditional financial paradigm seeks to understand financial markets by using models in which markets are perfect, which includes agents who are “rational” and update their beliefs correctly based on new information. By comparison, the new institutional economics approach attempts to provide a more realistic picture of economic processes, even in financial markets, by postulating several market imperfections, including the agents’ limited rationality. In contrast, behavioral finance completely challenges the rationality assumption and aims to improve the understanding of financial markets by assuming that, due to psychological factors, investors’ decisions will contradict the expected utility theory. However, the traditional, new institutional and the behavioral finance models all share one important feature: They are all based on the notion of a representative agent even though this mythological figure is dressed differently. Evolutionary finance suggests a model of portfolio selection and asset price dynamics that is explicitly based on the ideas of investors’ heterogeneity, dynamics and changes, learning and a natural selection of strategies. The paper suggests a systematization of this new approach, which is subsequently used to conduct a state-of-the-art literature survey and an evaluation of evolutionary finance research.