Fuzzy inductive reasoning, expectation formation and the behavior of security prices

Abstract

This paper extends the Santa Fe Artificial Stock Market Model (SFASM) studied by LeBaron, Arthur and Palmer (1999, Journal of Economic Dynamics and Control 23, 1487–1516) in two important directions. First, some might question whether it is reasonable to assume that traders are capable of handling a large number of rules, each with numerous conditions, as is assumed in the SFASM. We demonstrate that similar results can be obtained even after severely limiting the reasoning process. We show this by allowing agents the ability to compress information into a few fuzzy notions which they can in turn process and analyze with fuzzy logic. Second, LeBaron et al. have reported that the kurtosis of their simulated stock returns is too small as compared to real data. We demonstrate that with a minor modification to how traders go about deciding which of their prediction rules to rely on when making demand decisions, the model can in fact produce return kurtosis that is comparable to that of actual returns data.