Limited or Biased: Modeling Sub-Rational Human Investors in Financial Markets
This work addresses the lack of a comprehensive framework for modeling human sub-rationality in financial markets, which is an incremental advancement in behavioral finance.
The study tackled the problem of modeling sub-rational human investors in financial markets by introducing a flexible reinforcement learning model that incorporates five aspects of human sub-rationality, showing that bounded-rational and prospect-biased behaviors improve liquidity but diminish price efficiency, while myopia, optimism, and pessimism reduce market liquidity.
Human decision-making in real-life deviates significantly from the optimal decisions made by fully rational agents, primarily due to computational limitations or psychological biases. While existing studies in behavioral finance have discovered various aspects of human sub-rationality, there lacks a comprehensive framework to transfer these findings into an adaptive human model applicable across diverse financial market scenarios. In this study, we introduce a flexible model that incorporates five different aspects of human sub-rationality using reinforcement learning. Our model is trained using a high-fidelity multi-agent market simulator, which overcomes limitations associated with the scarcity of labeled data of individual investors. We evaluate the behavior of sub-rational human investors using hand-crafted market scenarios and SHAP value analysis, showing that our model accurately reproduces the observations in the previous studies and reveals insights of the driving factors of human behavior. Finally, we explore the impact of sub-rationality on the investor's Profit and Loss (PnL) and market quality. Our experiments reveal that bounded-rational and prospect-biased human behaviors improve liquidity but diminish price efficiency, whereas human behavior influenced by myopia, optimism, and pessimism reduces market liquidity.