Tuesday, April 04, 2006

Efficiency bias

Chris Dillow (author of Investors Chronicle page 42 comment, and Stumbling and mumbling blog) asked in the Investors Chronicle dated 31st Mar - 6th April, why people don't believe that markets are efficient.

Chris states:

"But why do so many people believe - contrary to both common sense and the evidence - that markets are inefficient, and that we can risklessly beat the index by using our own skill? I suspect numerous cognitive biases are to blame."

He adds,

"An obvious one is wishful thinking - we like to think there's easy money to be made. This is buttressed by the Lake Woebegon effect: we all believe we're smarter than all the other idiots in the market."

To both the above points, I would like to point to the existence and good performance of hedge funds, especially in the recent past. I am aware that the market is mostly efficient, in that one is not likely to easily find a mispriced asset, and once found, a majority of household investors have not got the resourceful capability to quickly or easily arbitrage it. But the existence of hedge funds and the large volumes of money that can be made from such undertakings undermines the theory of perfectly efficient markets. Investors might be delving into areas of knowledge previously only privy to hedge funds and may be inclined to take more risk for higher return. I suppose that the efficient part of the market is boring as an investment prospect because it puts everyone into the same box. We are sufficiently different as people when it comes to tastes, risk preference, etc, and some people will pay considerable amounts of money (premiums) to be different from the sheep. However, the sheep will find safety in numbers.

I think there is easy money to be made in the market, if you know where to look and – most importantly – have enough of it to start with. We live in a time when information is more readily available in depth and breadth, and those that have it will find arbitraging opportunities, created by those without full information. Just like accountants are forever devising new portfolios that are tax efficient, and remain so until the respective tax collecting arm of the respective government gets fuller information and imposes taxes retrospectively. But even then, it’s always cat and mouse because the accountant is forever arbitraging (in a different sense).

My bottom line is that, the market will be deemed fully efficient in my eyes when its participants have full information at all times. The latter is hard to come by and even harder to sustain, hence, an inefficient market.

3 Comments:

Anonymous AfroM said...

waa! I am crushed. I have been listening to Garrison Keillor for awhile, and had no idea that Lake woebegon was a fictional town! :)
seriously i cant belive that i actually thought it was a real place! oh boy. woe be gone.

Good post btw. may i ask which parts of the world economy you are currently looking at, or which hedge funds you checking out?

Tuesday, April 04, 2006 10:13:00 pm  
Blogger Curious said...

I look at all parts of the world economy and its goings-on, i.e.: financial economics, pure economics, political-economy, etc.

Yes, Lake Wobegon is a fictitious town in Minnesota. It is characterised by a real and pervasive human tendency to overestimate one’s achievements and capabilities in relation to others.

Wednesday, April 05, 2006 10:17:00 am  
Anonymous chris said...

I agree the market isn't fully efficient. I was merely warning investors that it's easy for them to overstate the extent of its inefficiency and the ease with which they can exploit this.
Also, it's doubtful whether hedge funds in general have as much skill as you claim. Check out "Superstars or average Joes" by harry Kat here:
http://www.cass.city.ac.uk/airc/papers.html
(There's lots of other interesting stuff there too).

Wednesday, April 05, 2006 11:34:00 am  

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