Market Force, Ecology, and Evolution

In financial markets, an excess of buying tends to drive prices up, and an
excess of selling tends to drive them down. This is called market impact.
Based on a simplified model for market making, it is possible to derive a
unique functional form for market impact. This can be used to formulate a
non-equilibrium theory for price formation. Commonly used trading
strategies, such as value investing, and trend following induce
characteristic dynamics in the price. Although there is a tendency for
self-fulfilling prophesies, this is not always the case; in particular,
many value-investing strategies fail to make prices reflect values. When
there is a diversity of perceived values, nonlinear strategies give rise
to excess volatility. Many market phenomena such as trends and temporal
correlations in volume and volatility have simple explanations. The theory
is both simple and experimentally testable. Under this theory there
is an emphasis on the interrelationships of strategies that makes it
natural to regard a market as a financial ecology. A variety of examples
show how diversity emerges automatically as new strategies exploit the
inefficiencies of old strategies. This results in capital reallocations
that evolve on longer time scales and cause apparent non-stationarities on
shorter time scales. The drive toward market efficiency can be studied in
the dynamical context of pattern evolution. The evolution of the capital
of a strategy is analogous to the evolution of the population of a
biological species. Several different arguments suggest that the time
scale for market efficiency is years to decades.