Investor Behavior, Dynamic and Irrational, Helps Tackle Financial Risk

If hell is other people, according to the philosopher Sartre, might financial risk also be other people? Prof. Bernard Dumas believes that this is one often overlooked element: “I’m convinced that prices on the stock exchange move more than is justified by the movement of the economy,” he says. “There’s some risk generated by other people in the market.” With their personal, sometimes irrational behavior, individuals create risk for other investors. Prof. Dumas’s research program will use empirical methods to describe market features like this, or “imperfections”, that generate uncertainty for investors. With the innovative models he is developing, capable of capturing the dynamic behavior of individual agents, this work could help create a more desirable equilibrium on the financial markets.

A number of factors contribute to the frictions that Prof. Dumas aims to capture with his new methods of modeling markets. Not all risk is accounted for in the form of tradable financial products, for instance. A market like this is considered incomplete and amplifies other risks present. Also, market operations have costs and investors look for balance; if the transaction costs on a trading platform are too high, they won’t make the trade. At the same time, an individual can simply miss a normally interesting opportunity to trade, because their attention is occupied elsewhere. Such unknowns and fluctuating motivations make investor behavior difficult to predict, but necessary for a more complete picture of the market.

Additional risk is generated by the heterogeneous investor population reacting to different cues. Some may perceive a market signal incorrectly, overreacting to positive signs and rushing to trade, which drives the price up for all investors. Others might respond to different signals altogether. The speculation fueled by the differing beliefs held by a diverse population has repercussions, by affecting investments by firms, for example. Prof. Dumas is interested in measuring the impact this has on the economy’s growth. The bigger question will be how regulators can reduce the negative effects of such speculation without hindering the economy at large, but, before any government can attempt to regulate and mitigate the risk of this volatility in the market, its sources need to be better understood.

As Prof. Dumas describes, in 2007, leading up to the financial crisis, some critical questions were not being asked: Who is on the other side of this trade, why do they behave the way they do, and is that rational? His novel approach to facing this problem, by creating a richer description of the population, will help him build broader, more dynamic models of financial market equilibrium. This contribution to the “economist’s toolbox” could have an impact not just for regulators, but for applications in many areas linked to the stock market, like defaults and credit pricing, pensions, real estate, or the labor market. Prof. Dumas believes that, in the near future, we will be devoting as much computing power to modeling financial markets as we do today for climate science. He and his successors leading this research program will make that possible with the knowledge and innovative tools produced, and made available for all.

Scientific title : AXA Chair in Socio-economic risks of financial markets

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Investor Behavior, Dynamic and Irrational, Helps Tackle Financial Risk

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