A team of Oxford University economists and scientists - including INET Oxford's Maarten Scholl and Prof J. Doyne Farmer - today published a new study illustrating how tools from ecology can help us better understand financial markets.
In the work, published in the Proceedings of the National Academy of Sciences of the United States of America, the researchers argue that studying markets as complex ecosystems rather than perfectly efficient machines can help regulators guard against damaging market volatility. And they show that changes to the wealth invested via different strategies within a ‘market ecology’ can help predict market malfunctions like mispricings, bubbles, and crashes.
Maarten Scholl, an INET Oxford Doctoral Student and one of the study’s authors, said, “Market ecology could serve as a key tool for preventing market meltdowns. Had regulators monitored new species of investors in the run up to the global financial crash, for example, they might have spotted brewing instability: the increasing popularity of securities was like the introduction of a new exotic species that unbalances an ecology and leads to an overpopulation crisis, then a crash.
“Financial crashes leave deep social and economic scars, but a market ecology perspective can help regulators better anticipate and even prevent some of this damage.”
“Financial crashes leave deep social and economic scars, but a market ecology perspective can help regulators better anticipate and even prevent some of this damage.” Maarten Scholl, study co-author and INET Oxford Doctoral Student
Financial economics remains dominated by the idea of ‘market efficiency’. On this view, prices reflect all available information and, since there are no undervalued or overvalued assets, there is no way to ‘beat’ the market to make consistent profits.
Yet evidence suggests market efficiency is extremely rare in the real world. For example, it is impossible to peg many of the biggest market fluctuations of the past few decades onto some identifiable new available information; in the crash of 1987, the US stock market fell 20% in a day yet researchers struggle to point to any new information that caused this.
Puzzles like these mean the world described by market efficiency can seem unfamiliar to market practitioners.
Today’s study invites financial economists to move beyond market efficiency. The authors argue that concepts and approaches from ecology can shed light on why prices can move so far from ‘fundamental values’ (the expected value of future dividend payments), and why prices are volatile even in the absence of relevant new information.
Rather than viewing markets as perfectly efficient, the study authors model them as complex ecosystems made up of different investors using different strategies and working within inherently ‘noisy’ and unpredictable contexts.
Using tools from ecology, they model different investor strategies – including non-professional investors, trend followers, and value investors – as different ‘species’ within a market ecology. They find that:
- Just as the status and health of biological ecosystems depend on the species present and their populations, the status and health of market ecosystems depend on market strategies and the wealth invested in them.
- Understanding the impact of, and interactions between, different investor species can help predict market malfunctions, just as understanding the impact and interactions of different biological species can help predict ecosystem instability or collapse.
- Similar to how animal populations within ecosystems can fluctuate indefinitely, market prices can stray very far from equilibrium and can also fluctuate indefinitely.
"Ecology provides a rich toolbox to help us think through the interaction of different kinds of investors within complex, shifting contexts, so it is not surprising that applying ecological tools to market modelling can provide deep insights into how and why markets move from lulls to bubbles to crashes, and back again.” Professor J. Doyne Farmer, study co-author and INET Oxford's Director of Complexity Economics
Professor J. Doyne Farmer, co-author of the study and INET Oxford's Director of Complexity Economics, said, “Though market efficiency is a cornerstone of financial economics, those who work in financial markets know the theory fails to explain what really happens.
“This raises the question: how to build a better understanding of how markets work? Ecology provides a rich toolbox to help us think through the interaction of different kinds of investors within complex, shifting contexts, so it is not surprising that applying ecological tools to market modelling can provide deep insights into how and why markets move from lulls to bubbles to crashes, and back again.”
