Scandinavian Working Papers in Economics

SIFR Research Report Series,
Institute for Financial Research

No 52: High-Speed Natural Selection in Financial Markets with Large State Spaces

Yuriy Fedyk and Johan Walden ()
Additional contact information
Yuriy Fedyk: Olin School of Business, Postal: Washington University
Johan Walden: Haas School of Business, Postal: University of California at Berkeley, 545 Student Services Building # 1900, CA 94720-1900, USA

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.

Keywords: Asset pricing; Market selection hypothesis; Natural selection

JEL-codes: G11; G12

38 pages, April 15, 2007

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