Financial market model explains continued presence of irrational traders

Persistence of Bounded Rationality in Financial Markets: An Evolutionary Game-Theoretic Model

Computer Science and Game Theory

Summary

Markets often have both rational traders and others who use simpler, less accurate decision rules, but classical ideas say the rational ones should take over. The authors model how these types interact like species in an ecosystem, with each type’s success depending on the other’s presence and certain trading costs. They find that both types can persist together when their interactions help each other, and that improving trading technology favors rational traders but doesn’t eliminate the others unless advantages are large. This helps explain why less-than-perfect trading behavior remains common in real markets.

What this means in practice

  • For financial model developers: Incorporate evolutionary game dynamics modeling coexistence of trader types to better simulate market behavior over time.
  • For algorithmic trading teams: Assess how cost reductions in disciplined trading strategies might shift market participant composition without fully removing noise traders.

A theory result. No direct application yet.

Authors

Cheng Zhang

Abstract

Classical theory predicts that irrational traders lose money to rational traders and are eventually driven out of the market. Yet noise trading, herding, and heuristic trading persist even in highly developed markets. We model a financial market as an ecology of two trading-behavior types, relatively rational (R) and boundedly rational (N), whose composition evolves under replicator dynamics according to relative performance. Each type's fitness depends on the share of the other type and on frictions. When the interaction is complementary, that is, rational traders profit from the mispricing created by boundedly rational traders while the latter benefit from the liquidity and price correction supplied by the former, and when the difference in frictions is moderate, a unique interior composition exists and is globally asymptotically stable: bounded rationality persists endogenously. When the interaction is antagonistic, the same point becomes a tipping threshold between two one-type regimes. Comparative statics show that lowering the costs of disciplined trading, as algorithmic and AI-based trading does, shifts the composition toward rational trading continuously but does not eliminate bounded rationality unless the cost advantage exceeds an explicit threshold.
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