Tuesday, 6 January 2009

Market (in)efficiency

S&M returns from the holiday season with a post on efficient markets. Chris says:
The claim “markets are inefficient” can imply at least two things:
1. The job of allocating capital to investment projects will be badly done by markets.
2. It’s possible for an individual to out-perform stock markets without taking on extra risk, by spotting under-priced assets.

This reminded me straight away of this paper (PDF) by Alfred Rappaport which is worth a read, even though I'm not 100% convinced by it any more. Rappaport basically says that 1 can be true, even if 2 is not. Markets can be informationally efficient (available information is immediately factored into the price) but allocatively inefficient (because the info is duff/irrelevant, investors are biased etc). So you can't beat the market, but the market can still be off-target. Which is a neat way of explaining things, but (I argued previously) perhaps doesn't tell us all that much.

2 comments:

Charlie Marks said...

Hate to broaden this to markets in general, but as an allocative mechanism markets are pretty flawed - from the perspective of ordinary people that is...

Information that markets lack: environmental and other social costs, decisions being made by other agents (rivals, consumers, etc.)

We might ask as well, efficient for whom?

For example, it's no doubt an efficiency measure to off-shore jobs to low-wage economies, to import workers from overseas and thus have more competitive labour markets, or to have the threat of unemployment as a tool for holding down wages.

But a host of problems result - those workers laid off will have a reduced spending power (bad news for an economy driven by retail & services), migrant workers don't necessarily stick around and so dependent sectors can suffer staff shortages as a result of demographic changes, and as regards employment insecurity, workers fearful of redundancy are likely to be less productive.

What matters is that in the short term, such efficiency measures are profitable...

Tom P said...

That's why stockmarkets are interesting. They ought to be a pure example of markets in action, but actually they often reveal how important psychological factors are, and how badly this can skew allocation of capital.