Are Markets Efficient or Irrational? Actually, a Bit of Both

By Lasse Pedersen

The market is just inefficient enough to reward skill, but efficient enough to discourage any more active investing than that.

One of the financial world’s great debates is whether markets are efficient, that is, whether prices reflect all available information and thus represent an asset’s fair value. For instance, does Apple’s stock fully reflect all available information about its products, expected profit growth and various risks to the firm?

One prominent opinion is that, yes, markets are fully efficient, a view that is associated with Eugene Fama, who won the Nobel Memorial Prize in Economic Sciences in 2013. Fama shared the prize with Yale University’s Robert Shiller, who is associated with the opposite view — namely, that market prices are inefficient because of investors’ behavioral biases, exuberance and irrationality, which drive prices away from fair value. (The prize that year also went to a third recipient, Fama’s fellow University of Chicago economist Lars Peter Hansen, whose work centers on the efficiency of economic models.)

The debate is heated because the answer is very important for investors and society at large. If markets really are efficient, then all investors should choose passive investing. Why? Because passive investing saves on costs, and you can’t beat an efficient market. If, on the other hand, the market is largely inefficient, then investors can extract profits via the pursuit of active investing while society is plagued by the harmful effects of asset bubbles and crashes.

Read full article as published in Institutional Investor

Lasse Pedersen is the John A. Paulson Professor of Finance and Alternative Investments.