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.
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 abundance 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 statistical uncertainty in profitability (which is adjusted to match real markets) makes this noisy and uncertain. Even in the long term, the market spends extended periods of time away from perfect efficiency. We show how core concepts from ecology, such as the community matrix and food webs, give insight into market behavior . The wealth dynamics of the market ecology explain how market inefficiencies spontaneously occur and gives insight into the origins of excess price volatility and deviations of prices from fundamental values.
R
population
abundance
D
large
A
(which is adjusted to match real markets)
R
far
away
R
apply to markets
give insight into market behavior
R
explains
explain