How Market Ecology Explains Market Malfunction
Maarten P. Scholl, Anisoara Calinescu and J. Doyne Farmer
28 September, 2020
Standard approaches to the theory of financial markets are based on equilibrium and efficiency. Here we develop an alternative based on concepts and methods developed by biologists, in which the wealth invested in a financial strategy is like the population of a species. We study a toy model of a market consisting of value investors, trend followers and noise traders. We show that the average returns of strategies are strongly density dependent, i.e. they depend on the wealth invested in each strategy at any given time. In the absence of noise the market would slowly evolve toward an efficient equilibrium, but the large statistical uncertainty in profitability makes this noisy and uncertain. Even in the long term, the market spends extended periods of time far from perfect efficiency. We show how core concepts from ecology, such as the community matrix and food webs, apply to markets. The wealth dynamics of the market ecology explains how market inefficiencies spontaneously occur and gives insight into the origins of excess price volatility and deviations of prices from fundamental values.