Natural Selection in Financial Markets: Does It Work?

Can investors with incorrect beliefs survive in financial markets and have a significant impact on asset prices? My paper addresses this issue by analyzing a dynamic general equilibrium asset pricing model with some investors having rational expectations while others having incorrect beliefs concerning the mean growth rate of the economy. In contrast to the existing literature such as Sandroni (2000) and Blume and Easley (2004), which implicitly focus on economies without growth, this paper finds the elasticity of intertemporal substitution plays an important role for survival in a growth economy. The analysis also suggests that natural selection alone is not a satisfactory justification for rational expectations because i) it may take a long time to effectively eliminate the impact of irrational investors; ii) even small differences in preferences can make an investor dominate the market in the long run, even if his belief substantially and persistently deviates from the truth. The robustness of these results is discussed in various extensions of the baseline model. Journal of Economic Literature Classification Numbers: B40, B52, C60, D50, D90, G12.