Blog - Investing Notes

March 7, 2006 - The Entropic Markets Hypothesis

Can the laws of physics and information theory help explain human psychology, specifically as exhibited by investors? In the December 2005 update of his paper entitled "The Physical Foundation of Human Mind and a New Theory of Investment", Jing Chen: (1) builds upon the similarities between the mathematics of information theory and of physical entropy to explain certain human thinking patterns; and, (2) uses this synthesis to unify understanding of the behavior of financial markets. He posits that human thinking patterns are adaptations evolved (mostly in hunter/gatherer mode) to acquire efficiently the resources needed for survival, as constrained by physical laws. In a mostly theoretical discussion, he offers the following insights:

• Information (as a reduction of entropy) is costly, and cost increases with value.
• The amount of information one can (intelligently) receive depends on: (1) how much information is available; and, (2) the ability to process it.
• Evolution has hard-coded in human brains information processing capabilities repetitively important to survival. Other processing abilities are learned.
• These principles explain investing-critical aspects of human psychology such as conservatism, framing, herding, overconfidence and loss aversion.
• Price and volume patterns observed in financial markets derive from: (1) the distribution of costs different investors are willing and able to bear to obtain information; and, (2) differences in processing ability among investors.
• Many of the market inefficiencies identified in behavioral finance flow naturally from this view of human information processing.

In summary, this synthesis of the theories of physical entropy, information processing and evolution offers an interesting perspective on investor psychology and financial market behavior.

For other broad perspectives on financial markets, see our blog entries of:

11/19/05 summarizing Emanuel Derman's thoughts on physics, financial markets and theories;

10/28/05 on the emergence of behavioral finance;

5/26/05 presenting Andrew Lo's Adaptive Markets Hypothesis, which has similarities to the above Entropic Markets Hypothesis;

3/28/05 for an overview of behavioral finance; and,

10/23/04 on Burton Malkiel's inexploitably efficient stock market.