The Effect of Cognitive Biases and Market Selection on Pricing Patterns

This work aims at investigating how behavioural biases and market selection influence pricing patterns. A general equilibrium model with agents affected by representativeness heuristic, conservatism, and anchoring and adjusting is introduced. The emergence of momentum and reversal, characterized by the three most widely adopted empirical methodologies, is investigated, and the differences and the relations among the three definitions are analyzed, highlighting that they can lead to contrasting results. Market selection is initially addressed by considering the competition between a Bayesian and a cognitive biased agent under the same equilibrium model, inquiring the degree of evolutionary stability of a warped learning process. The selection process culls the most efficient agents in making accurate predictions, whose biases may eventually lead to mispricing appearance. Therefore, an ecology of agents is successively considered, and the interaction among market participants is addressed both analytically and numerically. Both the composition of the market ecology and the evolutionary wealth reallocation process play a role in determining the asset valuation and, consequently, the realization of momentum and reversal.