A Threshold Model of Investor Psychology ROD CROSS 1 MICHAEL GRINFELD 2 HARBIR LAMBA 3 TIM SEAMAN 4 Abstract We introduce a class of agent-based market models founded upon simple descrip- tions of investor psychology. Agents are subject to various psychological tensions induced by market conditions, and endowed with a minimal ‘personality’. This per- sonality consists of a threshold level for each of the tensions being modeled, and the agent reacts whenever a tension threshold is reached. This paper considers an elementary model including just two such tensions. The first is ‘cowardice’, which is the stress caused by remaining in a minority position with respect to overall market sentiment, and leads to herding-type behaviour. The second is ‘inaction’, which is the increasing desire to act or re-evaluate one’s investment position. There is no inductive learning by agents, and they are only coupled via the global market price and overall market sentiment. Even incorporating just these two psychologi- cal tensions, important stylized facts of real market data, including fat-tails, excess kurtosis, uncorrelated price returns and clustered volatility over the timescale of a few days, are reproduced. By then introducing an additional parameter that ampli- fies the effect of externally generated market noise during times of extreme market sentiment, long-time volatility correlations can also be recovered. Keywords: investor psychology, volatility clustering, kurtosis, herding 1 Introduction For many years it has been apparent that models of financial markets using sets of stan- dard assumptions, often known as efficient market hypotheses (EMH), are not capable of reproducing important features of observed market behavior. This manifests itself most clearly in the real-world phenomena of non-Gaussian market statistics such as fat- tails, excess kurtosis and volatility clustering (and the corresponding market bubbles and crashes). The EMH allow for closed-form mathematical solutions to certain fundamental 1 Department of Economics, University of Strathclyde, Sir William Duncan Building, 130 Rottenrow Glasgow G4 0GE, Scotland, UK 2 Department of Mathematics, University of Strathclyde, Livingstone Tower, 26 Richmond Street, Glasgow G1 1XH, Scotland, UK 3 (corresponding author) Department of Mathematical Sciences, George Mason University, MS 3F2, 4400 University Drive, Fairfax, VA 22030 USA 4 Department of Mathematical Sciences, George Mason University, MS 3F2, 4400 University Drive, Fairfax, VA 22030 USA 1