CHAPTER 4 - Complex Evolutionary Systems in Behavioral Finance

Abstract

This chapter explores some behavioral finance models with evolutionary selection of heterogeneous trading strategies. When strategy selection is driven by short-run realized profits, trend-following strategies may destabilize asset markets. Asset price fluctuations are characterized by phases in which fundamentalists dominate and prices are close to fundamentals, suddenly interrupted by possibly long-lasting phases of price bubbles when trend-following strategies dominate the market and prices deviate persistently from fundamentals. Even in simple heterogeneous belief models, asset prices are difficult to predict and market timing based on the prediction of the start or the collapse of a bubble is extremely difficult and highly sensitive to noise. Simple evolutionary models therefore could provide an explanation. Laboratory experiments using human subjects confirm that coordination on simple trend-following strategies may arise in asset markets and cause persistent deviations from fundamentals. In a heterogeneous beliefs asset-pricing model, as long as prices fluctuate around their fundamental values, fundamentalist strategies do quite well in terms of accumulated profits. If there are no limits to arbitrage and fundamentalists can survive possibly long-lasting bubbles during which they suffer large losses, their strategy performs very well in the long run and may help stabilize markets.