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Limited or Biased: Modeling Sub-Rational Human Investors in Financial Markets

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  • Penghang Liu
  • Kshama Dwarakanath
  • Svitlana S Vyetrenko
  • Tucker Balch

Abstract

Human decision-making in real-life deviates significantly from the optimal decisions made by fully rational agents, primarily due to computational limitations or psychological biases. While existing studies in behavioral finance have discovered various aspects of human sub-rationality, there lacks a comprehensive framework to transfer these findings into an adaptive human model applicable across diverse financial market scenarios. In this study, we introduce a flexible model that incorporates five different aspects of human sub-rationality using reinforcement learning. Our model is trained using a high-fidelity multi-agent market simulator, which overcomes limitations associated with the scarcity of labeled data of individual investors. We evaluate the behavior of sub-rational human investors using hand-crafted market scenarios and SHAP value analysis, showing that our model accurately reproduces the observations in the previous studies and reveals insights of the driving factors of human behavior. Finally, we explore the impact of sub-rationality on the investor's Profit and Loss (PnL) and market quality. Our experiments reveal that bounded-rational and prospect-biased human behaviors improve liquidity but diminish price efficiency, whereas human behavior influenced by myopia, optimism, and pessimism reduces market liquidity.

Suggested Citation

  • Penghang Liu & Kshama Dwarakanath & Svitlana S Vyetrenko & Tucker Balch, 2022. "Limited or Biased: Modeling Sub-Rational Human Investors in Financial Markets," Papers 2210.08569, arXiv.org, revised Mar 2024.
  • Handle: RePEc:arx:papers:2210.08569
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    References listed on IDEAS

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    1. Richard H. Thaler & Amos Tversky & Daniel Kahneman & Alan Schwartz, 1997. "The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(2), pages 647-661.
    2. Selim Amrouni & Aymeric Moulin & Jared Vann & Svitlana Vyetrenko & Tucker Balch & Manuela Veloso, 2021. "ABIDES-Gym: Gym Environments for Multi-Agent Discrete Event Simulation and Application to Financial Markets," Papers 2110.14771, arXiv.org.
    3. Tucker Hybinette Balch & Mahmoud Mahfouz & Joshua Lockhart & Maria Hybinette & David Byrd, 2019. "How to Evaluate Trading Strategies: Single Agent Market Replay or Multiple Agent Interactive Simulation?," Papers 1906.12010, arXiv.org.
    4. Francis Larson & John List & Robert Metcalfe, 2016. "Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders," Natural Field Experiments 00534, The Field Experiments Website.
    5. Shlomo Benartzi & Richard H. Thaler, 1999. "Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments," Management Science, INFORMS, vol. 45(3), pages 364-381, March.
    6. Thomas Lux & Michele Marchesi, 1999. "Scaling and criticality in a stochastic multi-agent model of a financial market," Nature, Nature, vol. 397(6719), pages 498-500, February.
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    8. Brad M. Barber & Terrance Odean, 2002. "Online Investors: Do the Slow Die First?," The Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 455-488, March.
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    Cited by:

    1. Andrei Afilipoaei & Gustavo Carrero, 2023. "A Mathematical Model of Financial Bubbles: A Behavioral Approach," Mathematics, MDPI, vol. 11(19), pages 1-17, September.
    2. Benjamin Patrick Evans & Sumitra Ganesh, 2024. "Learning and Calibrating Heterogeneous Bounded Rational Market Behaviour with Multi-Agent Reinforcement Learning," Papers 2402.00787, arXiv.org.

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