Price Impact and Survival

Milton Friedman argued that irrational traders will consistently lose money, won’t survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders’ portfolio policies can deviate from their limits long after the price process approaches its longrun limit. We show, in contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders’ long-run survival. In sum, we explicitly show that price impact can persist whether or not the irrational traders survive. ∗Kogan and Ross are from the Sloan School of Management, MIT and NBER, Wang is from the Sloan School of Management, MIT, CCFR and NBER, and Westerfield is from the Economics Department, MIT. The authors thank Phil Dybvig, David Easley, Ming Huang, Wei Xiong and participants of the 2002 NBER Asset Pricing Summer Conference, the 2003 Econometric Society Meetings, the Liquidity Conference at the London School of Economics, the 2004 American Finance Association Meetings, and seminars at CarnegieMellon, Duke, University of Maryland, University of Minnesota, MIT, NYU, University of Oslo, Stockholm School of Economics, and University of Vienna for comments.