Wednesday, December 24, 2008

A Philosophy of Market Efficiency

I would define financial market inefficiency as a breakdown in the fundamental relationship between risk and reward. If an asset is priced such that one has a very high probability of excess gain and a very low probability of loss, then this is an inefficiency or undervaluation.

Conversely, if an asset is priced such that one has a very high probability of loss and a very low probability of gain, such as dot-com shares in the late 1990s, then you have another inefficiency, or an overvaluation.

This is associated with the participant’s bias, meaning that most market agents have a flawed view of reality and thus believe that the asset is correctly priced. In other words, they are either undervaluing or overvaluing reality, as a result of their own perception.

The mainstream and variant perceptions all have different views on an asset, and the price clears because most people do not see whatever the true inefficiency is. Thus, to have an inefficiency, most participants must vote that the market is, in fact, efficient.

Other elements come into play: boom-and-bust processes, self-fulfilling prophecies, information cascades, dysfunctional pricing models, barriers to exploitation, panic, euphoria, and so on.

To define it academically, one would need to draw from research in dynamical systems, behavioral finance, game theory, and other disciplines. One must look at the history of financial theory to recognize its flaws, and the flawed framework upon which it was built.

Financial theory and much of economic theory was modeled after 19th century physics; yet with the birth of quantum mechanics and relativity, physicists no longer look at the world in the same way. The logical underpinning of financial thinking remains outdated by two-hundred years.

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.