The financial markets are touted as being efficient by most leading economists. A large faction of economists tend to disagree and claim that the markets are only mostly efficient because humans are not fully rational agents.
An efficient market is one where all available information is accounted for in the price of an assett or good. If there is a deal to be found, then it has already been found by someone else. For instance, car dealership XYZ misprints a coupon and offers a $50k BMW for $25k to the first buyer. An efficient market hypothesis formulates that someone else will arrive as quickly as possible to snatch up the good deal.
An inefficient market is one where prices do not take into account all available information, or one in which the participating agents don’t make the most logical decisions. As in the above example the dealership offers a brand new BMW for 50% off… a great deal! But suppose they make the offer on Saturday in a 100% Orthodox community. Orthodox Jews can not handle money on the Sabbath and thus the BMW goes unpurchased until Sunday leaving the random out of town straggler to stumble upon the deal of a lifetime.
Aside from quirks like the above, the markets are usually efficient. If there is a deal to be had, it will be had. But I’d like to formulate my own hypothesis on inefficiency which stems from my understanding of the human psyche.
Markets are inefficient because human decisions are influenced by the following: overestimated future extraction of the good of an asset, greater fear of loss than hope at an equal sized gain, pride of ownership.
1.) Humans are extremely biased creatures. We have to be. In order to survive it’s necessary to make decisions without all of the data. This means bias. When it comes to a purchase or investment humans continue the pattern. Many of our purchase or investment decisions are made by comparing a list of highly complex options. Once the decision has been made (just go for it) the mind then plays the trick of soothing the resulting anxiety (did I make the right decision?) by hyping up the enjoyment that the purchase or investment will bring in the future. As the future has not arrived yet it’s perfectly understandable to assume that product X or investment Y will bring us more fun or wealth than we ever imagined. This is not rational and leads to inefficiencies in the market.
2.) Humans fear loss far more than they hope for an equal sized gain. If you were to take a survey of 1,000 people and ask them to value what their right arm was worth, take the average amount and triple it you’d still find that almost all of those surveyed would still rather keep their right arm than exchange it for the money. In another example we can take marriage. A young man dating a beautiful young woman often balks at the idea of marriage until he loses the potential bride, simply because the fear of the loss of other potentially better brides is greater than the hope of living a long and happy life with a beautiful and smart woman[1]. We hate risk, irrationally so, and it causes inefficiencies in the markets.
3.) Humans love to be owners. And once we own something, our mere ownership causes the item to become more valuable. Our pride in ownership is purely an emotional state which is the result of our inborn need to nurture. We are built to love, nurture and cultivate. It’s how God (or Evolution if you insist) designed us. Give us a baby, we feed it, a dog and we pet it, a plant and we water it, a car and we change the oil, a house and we fix it, some stock in a company and we watch it “grow”. It is this irrational attachment to our friends, children and even things that has allowed us to continue from generation to generation, but it also causes inefficiencies in the market place.
What does this all add up to? It adds up to two consequences:
Inefficiencies cause bubbles and bursts…mass movements towards and away from investments and goods fueled by irrationality. The bad thing about inefficient markets is that you may get caught in the burst unprepared. But the great thing is that inefficient markets provide opportunities for gain.
The main lesson is don’t be afraid about an economic crisis… it’s irrational… and besides it’s likely that another bubble is forming somewhere. If you’re quick you can probably catch it on the upswing!
- I also wonder, from an economic perspective a good woman is worth far more than her weight in gold, quite literally, why then would a man prefer to live the single uncommitted life? [↩]
While it’s not a perfect analogy… it’s pretty good. What’s your favorite analogy for constrained optimization?
