Nonlinear Sciences – Adaptation and Self-Organizing Systems
Scientific paper
1998-12-18
Nonlinear Sciences
Adaptation and Self-Organizing Systems
This version is totally rewritten, much more readable than the first. Several serious mistakes, as well as many minor ones, ar
Scientific paper
Markets have internal dynamics leading to excess volatility and other phenomena that are difficult to explain using rational expectations models. This paper studies these using a nonequilibrium price formation rule, developed in the context of trading with market orders. Because this is so much simpler than a standard inter-temporal equilibrium model, it is possible to study multi-period markets analytically. There price dynamics have second order oscillatory terms. Value investing does not necessarily cause prices to track values. Trend following causes short term trends in prices, but also causes longer-term oscillations. When value investing and trend following are combined, even though there is little linear structure, there can be boom-bust cycles,excess and temporally correlated volatility, and fat tails in price fluctuations. The long term evolution of markets can be studied in terms of flows of money. Profits can be decomposed in terms of aggregate pairwise correlations. Under reinvestment of profits this leads to a capital allocation model that is equivalent to a standard model in population biology. An investigation of market efficiency shows that patterns created by trend followers are more resistant to efficiency than those created by value investors, and that profit maximizing behavior slows the progression to efficiency. Order of magnitude estimates suggest that the timescale for efficiency is years to decades.
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