How market ecology explains market malfunction

What is it about?

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; that is, 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 calibrated 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. For example, at the efficient equilibrium, all three strategies have a mutualistic relationship, meaning that an increase in the wealth of one increases the returns of the others. The wealth dynamics of the market ecosystem explain how market inefficiencies spontaneously occur and gives insight into the origins of excess price volatility and deviations of prices from fundamental values.

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Photo by Avel Chuklanov on Unsplash

Photo by Avel Chuklanov on Unsplash

Why is it important?

We develop the mathematical analogy between financial trading strategies and biological species and show how to apply standard concepts from ecology to financial markets. We analyze the interactions of stereotypical trading strategies in ecological terms, showing that they can be competitive, predator–prey, or mutualistic, depending on the wealth invested in each strategy. The deterministic dynamics suggest that the system should evolve toward an efficient state where all strategies make the same average returns. However, this happens slowly and the evolution is so noisy that there are large fluctuations away from the efficient state, causing bursts of volatility and extended periods where prices deviate from fundamental values. This provides a conceptual framework that gives insight into the reasons why markets malfunction.