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The impact of active and passive investment on market efficiency: a simulation study

The impact of active and passive investment on market efficiency: a simulation study We create a simulated financial market and examine the effect of different levels of active and passive investment on fundamental market efficiency. In our simulated market, active, passive, and random investors interact with each other through issuing orders. Active and passive investors select their portfolio weights by optimizing Markowitz-based utility functions. We find that higher fractions of active investment within a market lead to an increased fundamental market efficiency. The marginal increase in fundamental market efficiency per additional active investor is lower in markets with higher levels of active investment. Furthermore, we find that a large fraction of passive investors within a market may facilitate technical price bubbles, resulting in market failure. By examining the effect of specific parameters on market outcomes, we find that that lower transaction costs, lower individual forecasting errors of active investors, and less restrictive portfolio constraints tend to increase fundamental market efficiency in the market. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Applied Economics Taylor & Francis

The impact of active and passive investment on market efficiency: a simulation study

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The impact of active and passive investment on market efficiency: a simulation study

Abstract

We create a simulated financial market and examine the effect of different levels of active and passive investment on fundamental market efficiency. In our simulated market, active, passive, and random investors interact with each other through issuing orders. Active and passive investors select their portfolio weights by optimizing Markowitz-based utility functions. We find that higher fractions of active investment within a market lead to an increased fundamental market efficiency. The...
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Publisher
Taylor & Francis
Copyright
© 2023 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group.
ISSN
1667-6726
eISSN
1514-0326
DOI
10.1080/15140326.2023.2188634
Publisher site
See Article on Publisher Site

Abstract

We create a simulated financial market and examine the effect of different levels of active and passive investment on fundamental market efficiency. In our simulated market, active, passive, and random investors interact with each other through issuing orders. Active and passive investors select their portfolio weights by optimizing Markowitz-based utility functions. We find that higher fractions of active investment within a market lead to an increased fundamental market efficiency. The marginal increase in fundamental market efficiency per additional active investor is lower in markets with higher levels of active investment. Furthermore, we find that a large fraction of passive investors within a market may facilitate technical price bubbles, resulting in market failure. By examining the effect of specific parameters on market outcomes, we find that that lower transaction costs, lower individual forecasting errors of active investors, and less restrictive portfolio constraints tend to increase fundamental market efficiency in the market.

Journal

Journal of Applied Economics – Taylor & Francis

Published: Dec 31, 2023

Keywords: Active investment; passive investment; financial market simulation; fundamental market efficiency

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