Behavioral Investors Versus Rational Investors: An Agent-based Computational Finance Model

Abstract

BSV (Barberis, Huang and Vishny [1998]) model is one of the most important explanative models in the area of behavioral finance. The existing BSV model is a model of how behavioral investors form beliefs, which produces both overreaction and mean-reversion for a wide range of parameter values. However, BSV model does not address the market equilibrium problems, which is critical for the asset pricing theory. Thus the following 2 questions are meaningful for the existing BSV model to be extended to an equilibrium model in which there are both BSV investors and rational investors in a market of risky asset: Will BSV model maintain its explanative power if rational investors are introduced? Who will lose money to their counterparts in trading of risky assets, the behavioral investors or the rational investors? In this paper, we present an agent-based computational model of the dynamic game between BSV investors and rational investors. The results of our model answer the above two questions. First, the introduction of rational investors to the market of risky asset will not eliminate the anomalies of overreaction and mean-reversion. We believe that it is because the unpredictability of BSV agents' behavior adds the total risk of risky asset, which in turn prevents rational investors from taking unlimited position to arbitrage. At that time, the risky asset is mispriced. Second, we do not find any evidence that the behavioral investors will lose money to their counterparts although their cognitive bias causes them to form a false kind of expectation on the future price of the risky asset. On the contrary, some weak evidence on that behavioral investors are less likely to bankrupt is reported. We contribute it to that BSV investors will be overcautious when the market price is going down continuously due to their cognitive bias, and then decrease the probability of bankruptcy. While at that time, rational investors will try to correct the market price distorted by BSV investors and thus take an additional arbitrage position, which may increase their returns, but will increase the probability of bankruptcy