Microscopic Simulation of the Stock Market: the Effect of Microscopic Diversity

(Received 10 March 1995, received in final form 3 April 1995, accepted 10 April 1995)

Abstract
Although the representative individual framework has been shown to be generally illegitimate and erroneous, it continues to be widely used for lack of a more suitable approach. In this paper, we present an alternative methodology for economic study - the microscopic simulation (MS) approach. We employ the MS methodology to study a basic model of the stock market formulated at the microscopic level - the level of the individual investor. We contrast macroscopic market behaviour arising from heterogenous as opposed to homogeneous (representative) investors. We study the macroscopic effects of different forms of the microscopic heterogeneity: heterogeneity of preference, expectation, strategy, investor-specific noise, and their combinations. We show that representative investor models lead to unrealistic market phenomena such as periodic booms and crashes. These periodic booms and crashes persist even when we relax the assumption of homogeneous preference. Only when heterogeneous expectations are introduced does the market behavior become realistic.