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Market Selection

  • Leonid Kogan
  • Stephen Ross
  • Jiang Wang
  • Mark M. Westerfield

The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders' consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

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File URL: http://www.nber.org/papers/w15189.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15189.

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Date of creation: Jul 2009
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Handle: RePEc:nbr:nberwo:15189
Note: AP
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  1. Alvaro Sandroni, 2000. "Do Markets Favor Agents Able to Make Accurate Predicitions?," Econometrica, Econometric Society, vol. 68(6), pages 1303-1342, November.
  2. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann,, . "The Survival of Noise Traders in Financial Markets," J. Bradford De Long's Working Papers _123, University of California at Berkeley, Economics Department.
  3. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
  4. Wei Xiong & Hongjun Yan, 2006. "Heterogeneous Expectations and Bond Markets," NBER Working Papers 12781, National Bureau of Economic Research, Inc.
  5. Bernard Dumas & Alexander Kurshev & Raman Uppal, 2009. "Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility," Journal of Finance, American Finance Association, vol. 64(2), pages 579-629, 04.
  6. 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.
  7. Blume, Lawrence & Easley, David, 1992. "Evolution and market behavior," Journal of Economic Theory, Elsevier, vol. 58(1), pages 9-40, October.
  8. Leonid Kogan & Stephen Ross, 2004. "The Price Impact and Survival of Irrational Traders," 2004 Meeting Papers 35, Society for Economic Dynamics.
  9. Lawrence Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Working Papers 01-06-031, Santa Fe Institute.
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