Market efficiency is like perfect competition - nice in theory not reflected in practice
In perfectly competitive markets, there are no extraordinary profits. New entrants and competitors will force trading profits to zero. In reality, frictions, costs, knowledge, uncertainty and risk all make markets less than perfectly competitive. Market efficiency is like frictionless environments in physics. It makes for a good effective starting point but cannot be relied on as the perfect description of markets in reality.
Similarly, there can sometimes be a trading edge by some investors, but it is unlikely to last forever. Any strategy or edge that is successful will eventually be competed away and more players try and employ the strategy. Alpha and efficiency is a dynamic concept that changes through time. A strategy could be successful because of the environment and it could be successful because not enough capital has taken away the extra profits. The alpha can fall only to return when less capital is committed to the strategy or the environment turns more favorable.
Markets that are less complex will be more efficient. It will attract more capital and investors. Hence, a single stock may be more likely to be efficient while the market overall may be more complex and thus less efficient. A stock that is new or more difficult to evaluate will be less efficient; however, the risks will be greater. Greater risk means that capital will be slower to move to eliminate inefficiencies. Market can be efficient with respect to reacting immediately to information but that does not mean that the processing is always done correctly.
Market efficiency is based on the assumption that market participants are rational, but in reality rationality is a difficult assumption to accept. Forecasts have biases and is generally of poor quality. Models have proved to be wrong. Investors have beliefs that they apply in a rational manner, but those beliefs could approve to be wrong.
Similarly, there can sometimes be a trading edge by some investors, but it is unlikely to last forever. Any strategy or edge that is successful will eventually be competed away and more players try and employ the strategy. Alpha and efficiency is a dynamic concept that changes through time. A strategy could be successful because of the environment and it could be successful because not enough capital has taken away the extra profits. The alpha can fall only to return when less capital is committed to the strategy or the environment turns more favorable.
Markets that are less complex will be more efficient. It will attract more capital and investors. Hence, a single stock may be more likely to be efficient while the market overall may be more complex and thus less efficient. A stock that is new or more difficult to evaluate will be less efficient; however, the risks will be greater. Greater risk means that capital will be slower to move to eliminate inefficiencies. Market can be efficient with respect to reacting immediately to information but that does not mean that the processing is always done correctly.
Market efficiency is based on the assumption that market participants are rational, but in reality rationality is a difficult assumption to accept. Forecasts have biases and is generally of poor quality. Models have proved to be wrong. Investors have beliefs that they apply in a rational manner, but those beliefs could approve to be wrong.
Which do you think is more likely?
Market efficiency - a simple set of descriptions
- No mistakes - investors get it "right". Markets are close to fair value.
- No biases - Prices are a weighted average of opinions but these opinions are rational.
- Markets are a fair game. No one can create a sustainable edge.
- Model of economy or asset valuation is well-known; investors always know the link between information and market reaction.
- Only paid for the cost of gathering information.
- Market only moves on surprises and the adjustment is immediate.
- No feedback effects.
- Risk premia may be time varying but always reflect risk properly.
Market inefficiency - a set of issues
- Market can make mistakes especially when facing change or inflection points.
- There are biases in markets because investors have behavior biases.
- On average market may be unbiased but it moves between greed and fear like a pendulum.
- There is skill from some investors, albeit few have it.
- Models of the economy are not well-known and change.
- Information gathering and processing rewarded.
- Surprises do not always lead to immediate new equilibrium.
- Potential endogenous feedback.
- Markets are cyclical, but prices do not reflect all risks all the time.
No comments:
Post a Comment