(connect to Part 1)


Based on all above construction, my model can generate a quite shaking proposition, speculating and rational investment have quite unequal position in evolutionary process and speculating is more competitive in terms of such comparison, as long as the market has been relatively speculative at the beginning it will be taken up by speculators ultimately, in contrast, the market dominated by rational investors can never be reached unless the speculators are extremely rare in terms of its absolute amount rather than its relative amount of speculators, that means no matter how many investors a market has, speculators can always survive. Noticed that, my conclusion about speculating behavior dominating market doesn’t rely on the bullish expectation and a certain amount of systematic risk, which are the necessary conditions of the survival of noisy traders in your model. Going further, an inverse proposition can also be drawn, which emphasize that the state market taken up by speculating behavior tends to be more and more stable as time pass away, in another words, in a absolutely speculative market, the difficulty to survive investors, who are input by some external power, like the supervisor admitting institutional investors into market to adjust market environment, is increasing constantly; but such stability is not owned by the state where rational investors take domination. What does this proposition mean? It’s quite probable that the policy to lower down price fluctuation and speculative degree by introducing expertise investors might invalidate in a given speculative market, of course, such prediction will also be effective for some other strategies to adjust market, like propagating the ideas about rational investment, providing more information for public investors and the forth, since people in market will ignore them, since speculating is more beneficial in certain market. In contrast, from your model, a smooth policy suggestion is to increase the professional degree of market if government hopes to stop the effects of noisy traders, due to professional investors’ rationality, without misperception.


Obviously, from conclusion to policy suggestion, my model implies different stories from yours and it’s convincing to attribute such difference to the two key assumptions mentioned in advance. But the more important I got from my model is the implication revealed by the contrast between our models. In fact, at least two important doubts can be summarized here.


Firstly, how should we recognize the behavior marked as irrationality? Obviously, my model deny the possibility that all irrational behaviors can be defined uniformly, or be researched in the representative way, since noisy trade and speculating, as two different types of irrationality, have so distinct relative position when competing with rational investment that any one of them aren’t suitable to represent the other. Put forward this logic, all the other types of behavior without meeting the rational conditions cannot be put into one category, one type of irrationality being not as competitive in evolution as rationality has nothing to do with the other types. So, if we really want to see the panorama of behavior evolution in financial market and many issues on its basis, like asset pricing, financial market efficiency etc., a well-defined irrational behavior set is crucial. Unfortunately, according to my reading spans, there is never an operative definition about irrationality or limited rationality until now, even this problem of how to define irrationality has seldom been proposed. So I think theories about irrationality and limited rationality deserve further researches.


Secondly, is a completed competitive financial market also a Pareto efficient market as effective market theory claimed? And can the financial market in real world become Pareto efficient by the efforts to reduce exchange cost? To both the questions, my answer is negative, since when it comes to the relation between exchange costs and economic efficiency, the proposition, market with positive exchange cost (EC) converge to a Pareto efficient market as EC heads up to zero, establishes if and only if EC is an external parameter, which means the variation of EC would definitely affects efficiency, but any change in market, like the price fluctuation, would never cause EC different. If the misperception in your model can be viewed as a sort of EC and the value can be adjusted by changing the weight of experienced or professional investors in market, it’s very reasonable to believe financial market in real world will be better and better (or say, be more like a Pareto efficient market) under government’s appropriate adjustment. However, it’s no reason to believe all variables with impact on market efficiency can be put into the category of external parameter, so that can be dealt with as exchange cost. Like the attempt in my model to involving the expectation people made into decision-making process by not distinguishing the ratio of different behaviors from the misperception, once considering the potential factors impacting market efficiency in an internalized way, a completed competitive market is no longer a Pareto efficient market, so that even if some efforts do work well to lower down the exchange cost, it doesn’t mean market will be better, inversely, it might turn worse and worse, such as the larger deviation between stock price and its rational value that if was reached, market would be Pareto efficient. Following this logic, we can go further to ask such questions, how should we understand the conceptual package, exchange cost, what are involved in and what aren’t? Does exchange cost paradigm is general enough to cover all probable factors that stop market in real world to be Pareto efficient? Defining exchange cost as the set of all factors with impacts on market efficiency but can be dealt with externalized or parameterized, defining completed competitive market as the market with exchange cost constantly equal to zero, what will such a completed competitive market become, more or less efficient than a noncompetitive market (some measurements of efficiency are needed), if we internalize some given behavior patterns and its effects on market efficiency into analytic models?


In my opinion, the second issues is more profound than the first one, since that directly topple the long-lasting convention in economics--- market in real world is not perfect, but only if we try to make it more like a complete competitive market by reducing exchange cost as more as possible, it can always be better. Therefore, Pareto optimization is still meaningful as it offers a never attainable but always approachable destination for economic development. However, my second doubt points out the possibility of a more pessimistic picture, Pareto optimization is quite probable a neither attainable nor approachable dream, an only ideal but not practical dream, just an Utopia.


All above is a brief summary of the core ideas in my paper and the main distinctions from your ideas shown in the classical paper “Noise Trader Risk in Financial Market”. Due to the limit of time and knowledge accumulation, there must be some points I didn’t consider deeply, if you find, please let me know. In addition, to mainly focus on academic opinions, I don’t mention any detail about my model, but if you would like, I could send you a more specific summary about my model to you.
It’s my pleasure to hear some comments and suggestions from you, also, I sincerely look forward to further discussing opinions mentioned in this email with you.


Best regards.
Yours sincerely,
Zhang