Behavioral finance FAQ / Glossary (Inefficiency)

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This is a separate page of the I-L section of the Glossary

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(market) Inefficiency, inefficient


01/4i,8i - 02/1i,2i,6i,8i,10i
- 04/9i - 05/5i
+ see efficiency,
anomaly

When prices and returns seem to "disobey" the rules of the game.

When things seem wrong ...unless the yardstick is wrong

Definition

Squares priced as circles.

In the sense of the EMH (see that acronym), an inefficiency / anomaly is

A market price or return

that seems inconsistent with what is known about the asset.

It seems not to match the rational anticipation
of risks and rewards that available information
and knowledge would command.

The mismatch between risks and rewards is the key


/

The EMH claims that well organized markets are
information-efficient.

In other words it makes the hypothesis that players base
their decisions on a (consistent) balance between

* monetary risks

* and monetary rewards

that they could rationally expect from the
available information
(or "fundamentals").

Behavioral finance refers also (*) in some degree to that normative theory,
but with a dissident view:

It tries to help detect those distorting "effects" so that investors can take

either advantage of them or precautions against them

It states that those asset market inefficiencies / anomalies are
  frequent
and sometimes large. This happens even in
   organized
markets (their main role is to give liquidity, not to control
   prices).

(if those effects are so frequent, why call them anomalies?).

(*) This paradox is that however disrespectful it is towards the EMH,

Behavioral finance is counter-dependent of that theory.

To be more an "anti-theory" than a theory is considered as a limitation
of Behavioral finance, see the BF article in this glossary.

Well, it just shows that realities are a bit more complex, and they resist
a clear-cut unification theory.

Types of inefficiencies

Measuring the depth and width of the gap.

Those inefficiencies can take two main directions, towards the
stratosphere or towards the abyss:

1) Overpricing / exaggerated return

2) Under pricing / insufficient returns /
    excessive volatility
.

Their scope and importance vary as those distortions can take the form
of:

Either small and temporary anomalous blips in returns, volatility
   and pricing,

Or large, persistent or even amplifying deviations, and in
    extreme cases, bubbles and crashes

.

What causes market inefficiencies?

Looking for clues:
deficient playing field or deficient players?

Those anomalies might come from:

The fact that markets are not always perfectly competitive,

because of:

* Insufficient liquidity,,

* Asymmetry of players (big / small ones...),

* Lack of information,

* Or whatever other structural or accidental causes.


Or market player's cognitive limitations and biases

(lack of attention, short memory, reasoning errors, simplified
heuristics...).

Or bullish / bearish collective sentiments.

They are often what explains the most excessive market
anomalies.

What if inefficiencies were the rule, and perfect efficiency a limit
case, often approached but nearly never reached?

(*) To find those messages: reach that BF group and, once there,
      1) click "messages" 2) enter your query in "search archives".

Members of the Behavioral Finance Group,
 please vote on the glossary quality at
BF polls

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This page last update: 30/07/15

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