Natural Selection in Financial Markets: Does it Work?

38 Pages Posted: 15 Jan 2008  

Hongjun Yan

Driehaus College of Business, DePaul University

Date Written: April 25, 2008

Abstract

Can investors with incorrect beliefs survive in financial markets and have a significant impact on asset prices? My paper addresses this issue by analyzing a dynamic general equilibrium model where some investors have rational expectations while others have incorrect beliefs concerning the mean growth rate of the economy. The main result is that an investor can survive if and only if he has the lowest survival index, which is a function of his belief accuracy, patience parameter and relative risk aversion coefficient. If preferences are held constant across all investors, then those with incorrect beliefs cannot survive in the limit, though calibrations reveal that the selection process is excessively slow. But if preferences vary across investors, even slightly, it becomes possible for an irrational investor to dominate the market, even if his beliefs persistently and substantially deviate from the truth.

Keywords: Market selection, asset pricing, general equilibrium, heterogeneous beliefs

JEL Classification: B40, B52, C60, D50, D90, G12

Suggested Citation

Yan, Hongjun, Natural Selection in Financial Markets: Does it Work? (April 25, 2008). Yale ICF Working Paper No. 08-01. Available at SSRN: https://ssrn.com/abstract=1083770 or http://dx.doi.org/10.2139/ssrn.1083770

Hongjun Yan (Contact Author)

Driehaus College of Business, DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/site/hongjunyanhomepage/

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