Fundamental traders' ‘tragedy of the commons’: Information costs and other determinants for the survival of experts and noise traders in financial markets

a r t i c l e i n f o JEL classification: C15 G14 D53 D82 Keywords: Information costs Noise trader Fundamental analysis Agent-based modeling This study explores the long-standing question about the survival of noise traders in financial markets through the relatively new method of agent-based modeling. We find that, in the normal case, there are two attractors for the ratio of experts versus noise traders. Either experts disappear almost entirely from the market, or they account for a certain fraction, with noise traders still being present. In the dynamic framework, the dynamics switches between these attractors, which leads to the emergence of some typical statistical features of financial markets, such as long memory, leptokurtic returns, and bubbles and crashes. Furthermore, we achieve a general approximation of the attractors and of the switching point in between from relevant determinants. Studies on financial markets commonly distinguish between two kinds of traders. Independent of their denotation (some studies call them rational, sophisticated or informed, others speak of arbitrageurs, smart money traders or fundamentalists), the common characteristic of the first group is that they derive their transactions from the analysis of true fundamental information. Though not trading arbitrarily, for the second group, this is not true. For example, so-called technical traders (or " chartists ") seek to identify patterns in the evolution of prices and extrapolate them. Yet, because of the myriad of behavioral patterns in this group and the unpredictability of their transactions, the second group has been known as " noise traders " (Black, 1986). It has been a long time since Milton Friedman (1953) stated that noise traders cannot survive in a market — a proposition which has been replicated in different model setups such as Figlewski (1978), Sandroni (2000) and Blume and Easley (2006). The unifying logic is that noise traders would lose money compared to rational agents as they trade on wrong beliefs (see also Alchian, 1950; Fama, 1965, for early proponents of this view). The opposite view is represented by a profound body of theoretic evidence which indicates that, under more or less restrictive assumptions, the long-run survival of noise traders is possible. Examples include DeLong et al. One of the most popular arguments for this belief has been proposed by DeLong et al. (1991), who construct an overlapping-generations model. If noise traders overestimate returns or underestimate risk, they tend (unconsciously) to accept higher risks …