A threshold model of investor psychology

Abstract

We introduce a class of agent-based market models founded upon simple descriptions of investor psychology. Agents are subject to various psychological tensions induced by market conditions, and endowed with a minimal 'personality'. This personality consists of a threshold level for each of the tensions being modeled, and the agent reacts whenever a tension threshold is reached. This paper considers an elementary model including just two such tensions. The first is 'cowardice', which is the stress caused by remaining in a minority position with respect to overall market sentiment, and leads to herding-type behaviour. The second is 'inaction', which is the increasing desire to act or re-evaluate one's investment position. There is no inductive learning by agents, and they are only coupled via the global market price and overall market sentiment. Even incorporating just these two psychological tensions, important stylized facts of real market data, including fat-tails, excess kurtosis, uncorrelated price returns and clustered volatility over the timescale of a few days, are reproduced. By then introducing an additional parameter that amplifies the effect of externally generated market noise during times of extreme market sentiment, long-time volatility correlations can also be recovered.

Market Statistics of a Psychology-Based Heterogeneous Agent Model

“…This statistical analysis is far more detailed than that of [12] and we show that all of the important details are replicated, over a wide range of parameter values. In Section 4 we show how the model can be used as a laboratory to investigate the effects of boundedly rational behaviour by focusing upon observed asymmetries in stock market returns.…”

“…It was noted in [12] that any non-trivial causal relationship between market sentiment and volatility will result in volatility clustering since the market sentiment typically displays long-time correlations. To date however there seems to have been very little, if any, research quantifying the correlation between the two.…”

“…Let P i be the price at which the i th investor last switched. If either p(n + 1) ∈ The only difference between the model presented above and the final model of [12] is that the inaction thresholds H i are reassigned after each switching rather than being fixed throughout the simulation. Thus many of the simplifications and assumptions that have been implicitly made in the above model have already been discussed there.…”

“…in [12,50]. The original motivation for this research was to develop a methodology whereby psychological (and irrational) effects could be systematically introduced into an otherwise efficient market and then to compare the output of the model against the stylized facts.…”

“…In Section 4 we show how the model can be used as a laboratory to investigate the effects of boundedly rational behaviour by focusing upon observed asymmetries in stock market returns. Since the models studied in Section 3 and in [12] are completely symmetric with respect to rising and falling prices, we investigate various ways of breaking this symmetry that result in similarly skewed market data. In Section 5 we offer some concluding remarks and directions for future research.…”