Behavioral finance FAQ / Glossary (Inefficiency)
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,
(market) Inefficiency, inefficient
01/4i,8i - 02/1i,2i,6i,8i,10i
- 04/9i - 05/5i + see efficiency,
When prices and returns seem to "disobey" the rules of the game.
When things seem wrong ...unless the yardstick is wrong
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
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
(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 /
Their scope and importance vary as those distortions can take the form
Either small and temporary anomalous blips in returns, volatility
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,
* 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
Or bullish / bearish collective sentiments.
They are often what explains the most excessive market
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
This page last update: 30/07/15