How market ecology explains market malfunction

Maarten P. Scholl (), Anisoara Calinescu and J. Farmer
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Maarten P. Scholl: Institute for New Economic Thinking, Oxford Martin School, University of Oxford, Oxford OX1 3QD, United Kingdom; Computer Science Department, University of Oxford, Oxford OX1 3QD, United Kingdom;
Anisoara Calinescu: Computer Science Department, University of Oxford, Oxford OX1 3QD, United Kingdom

Proceedings of the National Academy of Sciences, 2021, vol. 118, issue 26, e2015574118

Abstract: Standard approaches to the theory of financial markets are based on equilibrium and efficiency. Here we develop an alternative based on concepts and methods developed by biologists, in which the wealth invested in a financial strategy is like the abundance of a species. We study a toy model of a market consisting of value investors, trend followers, and noise traders. We show that the average returns of strategies are strongly density dependent; that is, they depend on the wealth invested in each strategy at any given time. In the absence of noise, the market would slowly evolve toward an efficient equilibrium, but the statistical uncertainty in profitability (which is calibrated to match real markets) makes this noisy and uncertain. Even in the long term, the market spends extended periods of time away from perfect efficiency. We show how core concepts from ecology, such as the community matrix and food webs, give insight into market behavior. For example, at the efficient equilibrium, all three strategies have a mutualistic relationship, meaning that an increase in the wealth of one increases the returns of the others. The wealth dynamics of the market ecosystem explain how market inefficiencies spontaneously occur and gives insight into the origins of excess price volatility and deviations of prices from fundamental values.

Keywords: market ecology; market efficiency; agent-based modeling (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (8)

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Working Paper: How Market Ecology Explains Market Malfunction (2021)
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