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Evolution of Market Heuristics

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  • Anufriev, M.

    ()
    (Universiteit van Amsterdam)

  • Hommes, C.H.

    (Universiteit van Amsterdam)

Abstract

The time evolution of aggregate economic variables, such as stock prices, is affected by market expectations of individual investors. Neo-classical economic theory assumes that individuals form expectations rationally, thus enforcing prices to track economic fundamentals and leading to an efficient allocation of resources. However, laboratory experiments with human subjects have shown that individuals do not behave fully rational but instead follow simple heuristics. In laboratory markets prices may show persistent deviations from fundamentals similar to the large swings observed in real stock prices. Here we show that evolutionary selection among simple forecasting heuristics can explain coordination of individual behavior leading to three different aggregate outcomes observed in recent laboratory market forecasting experiments: slow monotonic price convergence, oscillatory dampened price fluctuations and persistent price oscillations. In our model forecasting strategies are selected every period from a small population of plausible heuristics, such as adaptive expectations and trend following rules. Individuals adapt their strategies over time, based on the relative forecasting performance of the heuristics. As a result, the evolutionary switching mechanism exhibits path dependence and matches individual forecasting behavior as well as aggregate market outcomes in the experiments. Our results are in line with recent work on agent-based models of interaction and contribute to a behavioral explanation of universal features of financial markets.

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Bibliographic Info

Paper provided by Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance in its series CeNDEF Working Papers with number 07-06.

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Date of creation: 2007
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Handle: RePEc:ams:ndfwpp:07-06

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Postal: Dept. of Economics and Econometrics, Universiteit van Amsterdam, Roetersstraat 11, NL - 1018 WB Amsterdam, The Netherlands
Phone: + 31 20 525 52 58
Fax: + 31 20 525 52 83
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Web page: http://www.fee.uva.nl/cendef/
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Cited by:
  1. Pfajfar, D. & Zakelj, B., 2011. "Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory (Replaces CentER DP 2009-007)," Discussion Paper, Tilburg University, Center for Economic Research 2011-091, Tilburg University, Center for Economic Research.
  2. Harrison, Richard & Taylor, Tim, 2012. "Non-rational expectations and the transmission mechanism," Bank of England working papers, Bank of England 448, Bank of England.
  3. Mikhail Anufriev & Cars Hommes & Raoul Philipse, 2013. "Evolutionary selection of expectations in positive and negative feedback markets," Journal of Evolutionary Economics, Springer, Springer, vol. 23(3), pages 663-688, July.
  4. Cars Hommes & Thomas Lux, 2008. "Individual Expectations and Aggregate Behavior in Learning to Forecast Experiments," Kiel Working Papers 1466, Kiel Institute for the World Economy.
  5. Hommes, C.H. & Wagener, F.O.O., 2008. "Complex evolutionary systems in behavioral finance," CeNDEF Working Papers, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance 08-05, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  6. Anufriev, M. & Hommes, C.H., 2011. "Evolutionary Selection of Individual Expectations and Aggregate Outcomes in Asset Pricing Experiments (revised version of WP 09-09)," CeNDEF Working Papers, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance 11-06, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  7. Harrison, Richard & Taylor, Tim, 2012. "Misperceptions, heterogeneous expectations and macroeconomic dynamics," Bank of England working papers, Bank of England 449, Bank of England.
  8. Valentyn Panchenko & Sergiy Gerasymchuk & Oleg V. Pavlov, 2013. "Asset Price Dynamics with Heterogeneous Beliefs and Local Network Interactions," Discussion Papers, School of Economics, The University of New South Wales 2013-18, School of Economics, The University of New South Wales.
  9. Pfajfar, D. & Zakelj, B., 2012. "Uncertainty and Disagreement in Forecasting Inflation: Evidence from the Laboratory (Revised version of CentER DP 2011-053)," Discussion Paper, Tilburg University, Center for Economic Research 2012-072, Tilburg University, Center for Economic Research.
  10. Hommes, C.H., 2007. "Complexity, Evolution and Learning: a simple story of heterogeneous expectations and some empirical and experimental validation," CeNDEF Working Papers, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance 07-07, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  11. Anufriev, M. & Arifovic, J. & Ledyard, D. & Panchenko, V., 2010. "Efficiency of Continuous Double Auctions under Individual Evolutionary Learning with Full or Limited Information," CeNDEF Working Papers, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance 10-01, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.

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