Learning from Others in the Financial Market

TL;DR

This paper introduces a framework for understanding how multiple expectation models are adopted by market participants, addressing the circular nature of financial predictions and collective opinion formation.

Contribution

It proposes a new framework for organizing and analyzing multiple expectation models in financial markets, highlighting conditions for their adoption by participants.

Findings

Framework clarifies how expectations influence market dynamics

Conditions for majority adoption of models are identified

Addresses the circular problem of model validity in finance

Abstract

Prediction problems in finance go beyond estimating the unknown parameters of a model (e.g. of expected returns). This is because such a model would have to include parameters governing the market participants' propensity to change their opinions on the validity of that model. This leads to a well--known circular situation characteristic of financial markets, where participants collectively create the future they wish to estimate. In this paper, we introduce a framework for organizing multiple expectation models and study the conditions under which they are adopted by a majority of market participants.