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The Price Impact and Survival of Irrational Traders

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  • Kogan, Leonid
  • Ross, Stephen
  • Wang, Jiang
  • Westerfield, Mark

Abstract

Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price influence have been assumed to be the same. Often partial equilibrium analysis has been relied upon to examine the survival of irrational traders and to make inferences on their influence on prices. In this paper, we demonstrate that survival and influence on prices are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. In addition, in contrast to a partial equilibrium analysis, general equilibrium considerations matter since the ability of irrational traders to impact prices even when their wealth is diminishing can significantly affect their chances for long-run survival. In sum, in a long-run equilibrium, we explicitly show that price impact can occur whether or not the irrational traders survive. In related work, we show that even if the irrational traders survive they may have no price impact.

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Bibliographic Info

Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 4293-03.

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Date of creation: 21 Mar 2003
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Handle: RePEc:mit:sloanp:1841

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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

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