Information Theory and Market Behavior

Some recent empirical works indicate that investor performance and market patterns are primarily information driven instead of a behavioral phenomenon. However, Grossman and Stiglitz information theory and its variations offer little guidance in identifying informed investors and in distinguishing between securities with scarce information and those with widely available information. We show that most empirical evidences about market behaviors documented in the literature can be explained by a new information theory generalized from Shannon’s entropy theory of information. Investor performance and market patterns are the results of information processing by investors of different sizes with different background knowledge.