Capturing Animal Spirits in Financial Markets

Here’s a favorite snippet, “The dramatic bubbles and crashes, a product of madness of the crowd, result from a reasonable, albeit subjective behavior of each of the individuals. As we show in experiments involving human subjects, detection of decoupling indicates herding on a locked position, and allows us to predict critical phenomena (bubbles and crashes).”

Abstract (Via SSRN)

The current crisis in world finances clearly shows the failure of formal models of financial markets. Many experts believe that the failure of these models to capture crashes and bubbles is due to a missing variable: subjective human response which completely evades mathematical description. In this paper we provide a bridge between the empirical study of market ”mood” emergence out of individual behavior and a precise mathematical formulation capable to capture, explain and predict it. More precisely we provide a method by which the empirically observed soft human decision heuristics that underlie financial critical phenomena can be captured by formal agent-based rules. This enables us to detect periods of deterministic market evolution and predict (in controlled experiments) future states of the market. Our key observation is that the convergence of humans on a particular mood (fear or euphoria) corresponds to the ”decoupling” of the agents’ rules observed in the simulations: the decisions of the agents become independent (i.e. decoupled) of the latest inputs from the market. This describes the process in which individuals start to ignore new facts. The dramatic bubbles and crashes, a product of madness of the crowd, result from a reasonable, albeit subjective behavior of each of the individuals. As we show in experiments involving human subjects, detection of decoupling indicates herding on a locked position, and allows us to predict critical phenomena (bubbles and crashes). The dollar game thus provides formalism for reproducing the emergence of collective macroscopic trends and possibly a wider range of social macroscopic disruptions.

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About Miguel Barbosa

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06. November 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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