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High-Speed Natural Selection in Financial Markets with Large State Spaces

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  • Fedyk, Yuriy

    (Olin School of Business)

  • Walden, Johan

    ()
    (Haas School of Business)

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    Abstract

    Recent research has suggested that natural selection in financial markets may be a very slow process, taking hundreds of years. We show in a general equilibrium model that it may be much faster in markets with large state spaces. In many cases, the time it takes to wipe out irrational investors is inversely proportional to the number of stocks in the market, i.e., if it takes about 500 years with one stock, it takes about one year with 500 stocks. Thus, theoretically, natural selection can be very efficient even when there is high market uncertainty. The speed of the natural selection process is a known function of irrational investors' sentiment and of the real characteristics of the stock market. According to a calibration to U.S. stock data, it takes about fifty years for an irrational investor to be wiped out. This is in line with studies of individual investor underperformance.

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    Bibliographic Info

    Paper provided by Institute for Financial Research in its series SIFR Research Report Series with number 52.

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    Length: 38 pages
    Date of creation: 15 Apr 2007
    Date of revision:
    Handle: RePEc:hhs:sifrwp:0052

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    Keywords: Asset pricing; Market selection hypothesis; Natural selection;

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    1. Steven N. Kaplan & Per Stromberg, 2002. "Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses," NBER Working Papers 8764, National Bureau of Economic Research, Inc.
    2. Giannetti, Mariassunta & Yu, Xiaoyun, 2007. "Favoritism or Markets in Capital Allocation?," SIFR Research Report Series 50, Institute for Financial Research.
    3. Donald Morgan & Bertrand Rime & Philip E. Strahan, 2004. "Bank Integration and State Business Cycles," The Quarterly Journal of Economics, MIT Press, vol. 119(4), pages 1555-1584, November.
    4. Bortolotti, Bernardo & de Jong, Frank & Nicodano, Giovanna & Schindele, Ibolya, 2004. "Privatization and Stock Market Liquidity," CEPR Discussion Papers 4449, C.E.P.R. Discussion Papers.
    5. Bjönnes, Geir H. & Holden, Steinar & Rime, Dagfinn & Solheim, Haakon O.Aa., 2005. "'Large' vs. 'Small' Players: A Closer Look at the Dynamics of Speculative Attacks," SIFR Research Report Series 38, Institute for Financial Research.
    6. Massimo Massa & Andrei Simonov, 2006. "Hedging, Familiarity and Portfolio Choice," Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 633-685.
    7. Axelson, Ulf & Strömberg, Per & Weisbach, Michael S., 2007. "Why are Buyouts Levered? The Financial Structure of Private Equity Funds," SIFR Research Report Series 49, Institute for Financial Research.
    8. Massa, Massimo & Simonov, Andrei, 2001. "Reputation and Interdealer Trading. A Microstructure Analysis of the Treasury Bond Market," SIFR Research Report Series 5, Institute for Financial Research.
    9. Sundaram, Rangarajan K. & Yermack, David, 2006. "Pay Me Later: Inside Debt and Its Role in Managerial Compensation," SIFR Research Report Series 43, Institute for Financial Research.
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    Cited by:
    1. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does it Work?," Yale School of Management Working Papers amz2648, Yale School of Management, revised 01 May 2008.

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