Instability of financial markets by optimizing investment strategies investigated by an agent-based model

TL;DR

This paper uses an agent-based model to show that optimization instability caused by investors' inability to account for market impacts leads to unpredictable market price dynamics, challenging traditional equilibrium assumptions.

Contribution

It introduces a novel agent-based model incorporating technical analysis agents to demonstrate how optimization instability affects market stability and predictability.

Findings

Investment strategy parameters never converge, continuously changing over time.

Optimization instability causes market price dynamics to become unpredictable.

Market prices are unlikely to follow stable laws or be accurately modeled by equations.

Abstract

Most finance studies are discussed on the basis of several hypotheses, for example, investors rationally optimize their investment strategies. However, the hypotheses themselves are sometimes criticized. Market impacts, where trades of investors can impact and change market prices, making optimization impossible. In this study, we built an artificial market model by adding technical analysis strategy agents searching one optimized parameter to a whole simulation run to the prior model and investigated whether investors' inability to accurately estimate market impacts in their optimizations leads to optimization instability. In our results, the parameter of investment strategy never converged to a specific value but continued to change. This means that even if all other traders are fixed, only one investor will use backtesting to optimize his/her strategy, which leads to the time evolution of market prices becoming unstable. Optimization instability is one level higher than "non-equilibrium of market prices." Therefore, the time evolution of market prices produced by investment strategies having such unstable parameters is highly unlikely to be predicted and have stable laws written by equations. This nature makes us suspect that financial markets include the principle of natural uniformity and indicates the difficulty of building an equation model explaining the time evolution of prices.