Contribution 1c4.
Investor biases and efficiency
by Peter Greenfinch (first published on January 29th, 2003)

Do investors biases cancel out,
so that markets stay efficient?

   The "smoothing out" thesis

Some say that markets can be efficient
even if
investors have cognitive and emotional biases.

A kind of collective self organization would smooth out deviations.

There would be two reasons for that:

1) Investors have different risk attitudes and different risk / return / price estimates, more
      or less close or far from the "fair price".

But, in very liquid markets with many buyers and sellers, those estimates are supposed to
obey a Gaussian distribution
(=bell shaped) curve.

There would be in that case:

As many risk-prone investors on one side of the risk attitude curve, than there
    are risk-averse ones on the other side.

As many investors who underestimate the right value than investors who overestimate
     it, on each side of the median / the mean of the distribution curve of  estimated prices.

With a cluster near the price median / mean, and an harmonious and symmetric
   distribution around it. 

=> Thus the market price is supposed to be equal to that median / mean, and to reflect the
      best estimate of the real value.

2) even if that was not the case, and if the market price became too high or too low
      compared to the "real value", the most rational investors will seize the opportunity.

They would sell or buy until the price correspond to the fair one.

They will intervene quickly, in a race, so as not to miss that "arbitrage" opportunity.

=> Thus, very soon, the "right" price is reached.

Or at least the quotations would undulate nicely around it and quite close to it, with a small

There would not be any worthy arbitrage opportunity left.

  Two answers to that thesis

What if errors compound instead of compensate?

1) Nothing proves that there is an harmonious Gaussian distribution of
     investors attitudes or estimates.

2) "Rational" investor might consider that to calculate overpricing or underpricing is not relevant
       as long as price obeys a trend
and that this trend is not reverted.

=>  So their interest is to play on such trends as "conscious followers" (rational expectation theory)
       instead of playing against them.

Such a behavior adds to the momentum (positive feedback) instead of moderating it (what a
negative feedback or reversion to the mean would do).

Some influent investors (big hands or opinion leaders) can even have a tendency to "manipulate"
the market that way.

   Well, maybe we should identify better
      what investors consider "information"

Of course, if we define EMH as perfect reaction to information, those rational or irrational
exaggerations can be interpreted as a specific version of the EMH. We could label it the
"BF-enlarged EMH"

Prices are driven by new information, as the EMH states. But many investors might give more
importance to some information than to others.

For them:

"Exogenous information"

In other words the pieces of news
that come from the asset market :
prices, trends...


"Endogenous information"

In other words those on economic
fundamentals: economic risks and
uncertainties... earnings, interest
rates, growth prospects,

(*) see also Martin Sewell's paper on a "behavioral-based RWH").


 This page fist published Jan 29th, 2003.  Last update: 03/05/13

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