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

  • Fedyk, Yuriy

    (Olin School of Business)

  • Walden, Johan


    (Haas School of Business)

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    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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    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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    1. Giannetti, Mariassunta & Yu, Xiaoyun, 2007. "Favoritism or Markets in Capital Allocation?," SIFR Research Report Series 50, Institute for Financial Research.
    2. 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.
    3. Massa, Massimo & Simonov, Andrei, 2004. "Hedging, Familiarity and Portfolio Choice," SIFR Research Report Series 21, Institute for Financial Research.
    4. Donald Morgan & Bertrand Rime & Philip Strahan, 2003. "Bank Integration and State Business Cycles," NBER Working Papers 9704, National Bureau of Economic Research, Inc.
    5. Steven N. Kaplan & Per Strömberg, 2004. "Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses," Journal of Finance, American Finance Association, vol. 59(5), pages 2177-2210, October.
    6. Axelson, Ulf & Stromberg, Per & Weisbach, Michael S., 2008. "Why Are Buyouts Levered? The Financial Structure of Private Equity Funds," Working Paper Series 2008-15, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    7. Bortolotti, Bernardo & de Jong, Frank & Nicodano, Giovanna & Schindele, Ibolya, 2007. "Privatization and stock market liquidity," Journal of Banking & Finance, Elsevier, vol. 31(2), pages 297-316, February.
    8. Geir H. Bjønnes & Steinar Holden & Dagfinn Rime & Haakon O. Aa. Solheim, 2009. "'Large' vs. 'Small' Players: A Closer Look at the Dynamics of Speculative Attacks," CESifo Working Paper Series 2518, CESifo Group Munich.
    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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