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7.3 Financial Market Efficiency

Learning Objectives

  1. In what senses can financial markets be efficient or inefficient?
  2. What is portfolio diversification and sectoral asset allocation, and how do they help investors to earn market returns?

Now here is the freaky thing. While at any given moment, most investors’ valuations are wrong (too low or too high), the market’s valuation, given the information available at that moment, is always correct, though in a tautological or circular way only. You may recall from your principles course that markets “discover” prices and quantities. If the market price of anything differs from the equilibrium price (where the supply and demand curves intersect), market participants will bid the market price up or down until equilibrium is achieved. In other words, a good, including a financial security, is worth precisely what the market says it is worth.

At any given time, some people expect the future market price of an asset will move higher or that it is currently underpriced, a value or bargain, so to speak. They want to buy. Others believe it will move lower, that it is currently overpriced. They want to sell. Sometimes the buyers are right and sometimes the sellers are, but that is beside the point, at least from the viewpoint of economic efficiency. The key is that the investor who values the asset most highly will come to own it because he’ll be willing to pay the most for it. Financial markets are therefore allocationally efficient. In other words, where free markets reign, assets are put to their most highly valued use, even if most market participants don’t know what that use or value is. That’s really remarkable when you think about it and goes a long way to explaining why many economists grow hot under the collar when governments create barriers that restrict information flows or asset transfers.

Financial markets are also efficient in the sense of being highly integrated. In other words, prices of similar securities track each other closely over time and prices of the same security trading in different markets are identical, or nearly so. Were they not, arbitrage, or the riskless profit opportunity that arises when the same security at the same time has different prices in different markets, would take place. By buying in the low market and immediately selling in the high market, an investor could make easy money. Unsurprisingly, as soon as an arbitrage opportunity appears, it is immediately exploited until it is no longer profitable. (Buying in the low market raises the price there, while selling in the high market decreases the price there.) Therefore, only slight price differences that do not exceed transaction costs (brokerage fees, bid-ask spreads, etc.) persist.

The size of those price differences and the speed with which arbitrage opportunities are closed depend on the available technology. Today, institutional investors can complete international financial market trades in just seconds and for just a few hundredths or even thousandths of a percent. In the early nineteenth century, U.S.-London arbitrageurs (investors who engage in arbitrage) confronted lags of several weeks and transaction costs of several percent. Little wonder that price differentials were larger and more persistent in the early nineteenth century. But the early markets were still rational because they were as efficient as they could be at the time. (Perhaps in the future, new technology will make seconds and hundredths of a percent look pitifully archaic.)

Arbitrage, or the lack thereof, has been the source of numerous jokes and gags, including a two-part episode of the 1990s comedy sitcom Seinfeld. In the episodes, Cosmo Kramer and his rotund friend Newman (the postal worker) decide to try to arbitrage the deposit on cans and bottles of soda, which is 5 cents in New York, where Seinfeld and his goofy friends live, and 10 cents in Michigan. The two friends load up Newman’s postal truck with cans and head west, only to discover that the transaction costs (fuel, tolls, hotels, and what not) are too high, especially given the fact that Kramer is easily sidetracked.en.wikipedia.org/wiki/The_Bottle_Deposit,_Part_1 High transaction costs also explain why people don’t arbitrage the international price differentials of Big Macs and many other physical things.www.economist.com/markets/Bigmac/Index.cfm Online sites like eBay, however, have recently made arbitrage in nonperishables more possible than ever by greatly reducing transaction costs.

In another joke (at least I hope it’s a joke!), two economics professors think they see an arbitrage opportunity in wheat. After carefully studying all the transaction costs—freight, insurance, brokerage, weighing fees, foreign exchange volatility, weight lost in transit, even the interest on money over the expected shipping time—they conclude that they can make a bundle buying low in Chicago and selling high in London. They go for it, but when the wheat arrives in London, they learn that a British ton (long ton, or 2,240 pounds) and a U.S. ton (short ton, or 2,000 pounds) are not the same thing. The price of wheat only appeared to be lower in Chicago because a smaller quantity was being priced.

Some economists believe financial markets are so efficient that unexploited profit opportunities like arbitrage are virtually impossible. Such extreme views have also become the butt of jokes, like the one where a young, untenured assistant professor of economics bends over to pick up a $20 bill off the sidewalk, only to be chided by an older, ostensibly wiser, and indubitably tenured colleague who advises him that if the object on the ground were real money, somebody else would have already have picked it up.robotics.caltech.edu/~mason/ramblings/efficientSidewalkTheory.html; www.indexuniverse.com/sections/research/123.html But we all know that money is sometimes lost and that somebody else is lucky enough to pocket it. At the same time, however, some people stick their hands into toilets to retrieve authentic-looking $20 bills, so we also know that things are not always what they seem. Arbitrage and other unexploited profit opportunities are not unicorns. They do exist on occasion. But especially in financial markets, they are so fleeting that they might best be compared to kaons or baryons, rare and short-lived subatomic particles.

In an efficient market, all unexploited profit opportunities, not just arbitrage opportunities, will be eliminated as quickly as the current technology set allows. Say, for example, the rate of return on a stock is 10 percent but the optimal forecast or best guess rate of return, due to a change in information or in a valuation model, was 15 percent. Investors would quickly bid up the price of the stock, thereby reducing its return. Remember that R = (C + Pt1 – Pt0)/Pt0. As Pt0 , the price now, increases, R must decrease. Conversely, if the rate of return on a stock is currently 10 percent but the optimal forecast rate of return dropped to 5 percent, investors would sell the stock until its price decreased enough to increase the return to 10 percent. In other words, in an efficient market, the optimal forecast return and the current equilibrium return are one and the same.

Financial market efficiency means that it is difficult or impossible to earn abnormally high returns at any given level of risk. (Remember, returns increase with risk.) Yes, an investor who invests 100 percent in hedge fundsA type of relatively unregulated mutual fund that engages in sophisticated trading strategies. Only wealthy individuals and institutional investors are allowed to invest directly in such funds. will likely garner a higher return than one who buys only short-dated Treasury notes. Holding risk (and liquidity) constant, though, returns should be the same, especially over long periods. In fact, creating a stock portfolio by throwing darts at a dartboard covered with ticker symbols returns as much, on average, as the choices of experienced stock pickers choosing from the same set of companies. Chimpanzees and orangutans have also done as well as the darts and the experts. Many studies have shown that actively managed mutual funds do not systematically outperform (provide higher returns than) the market. In any given period, some funds beat the market handily, but others lag it considerably. Over time, some stellar performers turn into dogs, and vice versa. (That is why regulators force financial firms to remind investors that past performance is not a guarantee of future returns.)

That is not to say, however, that you shouldn’t invest in mutual funds. In fact, mutual funds are much less risky (have lower return variability) than individual stocks or any set of stocks you are likely to pick on your own. Portfolio diversificationEntails investing in a relatively large number of issuers within an asset class, such as buying the shares of hundreds of corporations rather than just one or a few in order to reduce return risk. Some of the investments will go sour, others will flourish, and most will fall in between., the investment strategy often described as not putting all of your eggs (money) in one basket (asset), is a crucial concept. So-called indexed mutual funds provide diversification by passively or automatically buying a broad sample of stocks in a particular market (e.g., the Dow or NASDAQ) and almost invariably charge investors relatively low fees.

Sectoral asset allocationEntails investing in a variety of different asset classes (e.g., some bonds, some stocks, and some commodities) consistent with the investor’s goals and lifecycle stage. is another important concept for investors. A basic strategy is to invest heavily in stocks and other risky assets when young but to shift into less volatile assets, like short-term bonds, as one nears retirement or other cash-out event. Proper diversification and allocation strategies will not help investors to “beat the market,” but they will definitely help the market from beating them. In other words, those strategies provide guidelines that help investors to earn average market returns safely and over the long term. With luck, pluck, and years of patience, modest wealth can be accumulated, but a complete bust will be unlikely.

Stop and Think Box

I once received the following hot tip in my e-mail:

Saturday, March 17, 2007

Dear Friend:

If you give me permission…I will show you how to make money in a high-profit sector, starting with just $300–$600. The profits are enormous. You can start with as little as $300. And what’s more, there is absolutely no risk because you will “Test Drive” the system before you shell out any money. So what is this “secret” high-profit sector that you can get in on with just $300–$600 or less??? Dear Friend, it’s called “penny stocks”—stocks that cost less than $5 per share. Don’t laugh—at one time Wal-Mart was a “penny stock.” So was Microsoft. And not too long age, America Online was selling for just .59 cents a share, and Yahoo was only a $2 stock. These are not rare and isolated examples. Every month people buy penny stocks at bargain prices and make a small fortune within a short time.

Very recently, these three-penny stocks made huge profits. In January ARGON Corp. was at $2.69. Our indicators picked up the beginning of the upward move of this stock. Within three months the stock shot up to $28.94 a share, turning a $300 investment into $3,238 in just three months. In November Immugen (IMGN) was at $2.76 a share. We followed the decline of this stock from $13 to as little as $1.75 a share. But our technicals were showing an upward move. Stock went up to $34.10 a share. An investment of $500 would have a net gain of $5,677. RF Micro Devices was at $1.75 in August 1999. It exploded to $65.09 a share by April 2000. An investment of only $500 in this stock would have a net profit of $18,097. In fact, the profits are huge in penny stocks. And smart investors who picked these so-called penny stocks made huge profits. They watched their money double seemingly day after day, week after week, month after month. Double, triple, quadruple, and more.

Should I buy? Why or why not?

I did not invest, and you shouldn’t either if confronted with a similar scenario. If the individual who sent the message really knows that the stock is going to appreciate, why should he tell anyone? Shouldn’t he buy the shares himself, borrowing to the hilt if necessary to do so? So why would he try to entice me to buy this stock? He probably owns a few (hundred, thousand, million) shares and wants to drive their price up by finding suckers and fools to buy it so he can sell. This is called “pumping and dumping”www.fool.com/foolu/askfoolu/2002/askfoolu020107.htm and it runs afoul of any number of laws, rules, and regulations, so you shouldn’t think about sending such e-mails yourself, unless you want to spend some time in Martha Stewart’s prison.www.csmonitor.com/2004/1008/p01s01-usju.html And don’t think you can free-ride on the game, either. One quirky fellow named Joshua Cyr actually tracks the prices of the hot stock tips he has received, pretending to buy 1,000 shares of each. On one day in March 2007, his Web site claimed that his pretend investment of $70,987.00 was then worth a whopping $9,483.10, a net gain of −$61,503.90. (To find out how he is doing now, browse http://www.spamstocktracker.com.) Even if he had bought and sold almost immediately, he would have still lost money because most stocks experienced very modest and short-lived “pops” followed by quick deflations. A few of us are idiots, but most are not (or we are too poor or too lazy to act on the tips). Learning this, the scammers started to pretend that they were sending the message to a close friend to make it seem as though the recipient stumbled upon important inside information. (For a hilarious story about this, browse http://www.marketwatch.com/news/story/errant-e-mails-nothing-more-another/story.aspx?guid={1B1B5BF1-26DE-46BE-BA34-C068C62C92F7}.) Beware, because their ruses are likely to grow increasingly sophisticated.

In some ways, darts and apes are better stock pickers than people because the fees and transaction costs associated with actively managed funds often erase any superior performance they provide. For this reason, many economists urge investors to buy passively managed mutual funds or exchange traded funds (ETFs) indexed to broad markets, like the S&P or the Dow Jones Industrial Average, because they tend to have the lowest fees, taxes, and trading costs. Such funds “win” by not losing, providing investors with an inexpensive way of diversifying risk and earning the market rate of return, whatever that happens to be over a given holding period (time frame).

Key Takeaways

  • Markets are efficient if they allocate resources to their most highly valued use and if excess profit opportunities are rare and quickly extinguished.
  • Financial markets are usually allocationally efficient. In other words, they ensure that resources are allocated to their most highly valued uses, and outsized risk-adjusted profits (as through arbitrage, the instantaneous purchase and sale of the same security in two different markets to take advantage of price differentials) are uncommon and disappear rapidly.
  • Portfolio diversification and sectoral asset allocation help investors to earn average market returns by spreading risks over numerous assets and by steering investors toward assets consistent with their age and financial goals.