We propose a theory of asset pricing based on heterogeneous agents who continually adapt their expectations to the market that these expectations aggregatively create. And we explore the implications of this theory computationally using our Santa Fe artificial stock market. Asset markets, we argue, have a recursive nature in that agents ’ expectations are formed on the basis of their anticipations of other agents ’ expectations, which precludes expectations being formed by deductive means. Instead traders continually hypothesize—continually explore—expectational models, buy or sell on the basis of those that perform best, and confirm or discard these according to their performance. Thus individual beliefs or expectations become endogenous to the market, and constantly compete within an ecology of others ’ beliefs or expectations. The ecology of beliefs co-evolves over time. Computer experiments with this endogenous-expectations market explain one of the more striking puzzles in finance: that market traders often believe in such concepts as technical trading, “market psychology, ” and bandwagon effects, while academic theorists believe in market efficiency and a lack of speculative opportunities. Both views, we show, are correct, but within different regimes. Within a regime where investors explore alternative expectational models at a low rate, the market settles into the rational-

In a duopoly model of informed speculation, we show that overconfidence may strictly dominate rationality since an overconfident trader may not only generate higher expected profit and utility than his rational opponent, but also higher than if he were also rational. This occurs because overconfidence acts like a commitment device in a standard Cournot duopoly. As a result, for some parameter values the Nash equilibrium of a two-fund game is a Prisoner's Dilemma in which both funds hire overconfident managers. Thus, overconfidence can persist and survive in the long run. 2 The rational expectations hypothesis implies that economic agents make decisions as though they know a correct probability distribution of the underlying uncertainty. According to the traditional view (Alchian (1950) and Friedman (1953)), the rational expectations hypothesis is empirically plausible because rational beliefs are better able to survive the market test than irrational beliefs. Yet, the empirical liter...

Experimental results on the ultimatum game show clearly that (1) large fractions of players offer a 'fair' allocation and (2) that unfair (but positive) offers are systematically rejected. We offer an explanation of this behavior using the 'indirect evolutionary approach' which is based on the assumption that players behave rationally for given preferences but that their preferences change through an evolutionary process. We prove that despite anonymous interaction a preference for punishing unfair offers is an evolutionarily successful strategy if players interact in groups. This leads players to split the resource equally almost always. However, the equal split is not due to 'true fairness' (or 'altruism') but is entirely caused by the (justified) fear that unfair offers might be rejected. Our result can be interpreted as presenting an evolutionary foundation for the emergence of social norms. JEL-- classification numbers: C73, D 83. We thank Georg Noldeke, Karl Schlag,...

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Markets have internal dynamics leading to excess volatility and other phenomena that are difficult to explain using rational expectations models. This paper studies these using a nonequilibrium price formation rule, developed in the context of trading with market orders. Because this is so much simpler than a standard inter-temporal equilibrium model, it is possible to study multi-period markets analytically. There price dynamics have second order oscillatory terms. Value investing does not necessarily cause prices to track values. Trend following causes short term trends in prices, but also causes longer-term oscillations. When value investing and trend following are combined, even though there is little linear structure, there can be boom-bust cycles, excess and temporally correlated volatility, and fat tails in price fluctuations. The long term evolution of markets can be studied in terms of flows of money. Profits can be decomposed in terms of aggregate pairwise correlations. Under reinvestment of profits this leads to a capital allocation model that is equivalent to a standard model in population

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Several studies indicate that humans are overconfident about their own (relative) abilities. We propose a notion of pragmatic beliefs, and show through an example that this concept can shed light on why overconfidence emerges. Through the example, we also shed light on the idea that that ’bounded rationality ’ may arise endogenously in a game- without assuming complexity costs.

Attempts to model interstellar colonization may seem hopelessly compromised by uncertainties regarding the technologies and preferences of advanced civilizations. If light speed limits travel speeds, however, then a selection effect may eventually determine frontier behavior. Making weak assumptions about colonization technology, we use this selection effect to predict colonists ’ behavior, including which oases they colonize, how long they stay there, how many seeds they then launch, how fast and far those seeds fly, and how behavior changes with increasing congestion. This colonization model explains several astrophysical puzzles, predicting lone oases like ours, amid large quiet regions with vast unused resources.

Abstract: This paper revisits the Kareken-Wallace model of exchange rate formation in a twocountry overlapping generations world. Following the seminal paper by Arifovic (Journal of Political Economy, 104, 1996, 510 – 541) we investigate a dynamic version of the model in which agents ’ decision rules are updated using genetic algorithms. Our main interest is in whether the equilibrium dynamics resulting from this learning process helps to explain the main stylized facts of free-floating exchange rates (unit roots in levels together with fat tails in returns and volatility clustering). Our time series analysis of simulated data indicates that for particular parameterizations, the characteristics of the exchange rate dynamics are, in fact, very similar to those of empirical data. The similarity appears to be quite insensitive with respect to some of the ingredients of the genetic algorithm (i.e. utility-based versus rank-based or tournament selection, binary or real coding). However, appearance or not of realistic time series characteristics depends crucially on the mutation probability (which should be low) and the number of agents (not more than about 1000). With a larger population, this collective learning dynamics looses its realistic appearance and instead exhibits regular periodic oscillations of the agents ’ choice variables.

The paper considers the evolution of portfolio rules in incomplete markets with stationary returns and endogenous prices. The ultimate success of a portfolio rule is measured by the wealth share the rule is eventually able to conquer in competition with other portfolio rules. We give necessary and sufficient conditions for portfolio rules to be evolutionary stable in an incomplete market. In the case of i.i.d. returns we identify a simple portfolio rule to be the unique evolutionary stable strategy. Moreover, we demonstrate that mean-variance optimization is not evolutionary stable while the CAPM-rule always imitates the best portfolio rule and survives.