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

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.

The truth lies somewhere in between: Markets are neither perfectly efficient nor grossly inefficient. But the degree of inefficiency doesn’t just lie somewhere on that continuum. Markets are, in fact, efficiently inefficient. To appreciate this idea and how it can help you attempt to beat the market, it is worthwhile to put into context the two extreme views.

First, the market cannot be fully efficient, as Fama would have us believe, because if it were, no one would have an incentive to be active, so who would make the market efficient? Further, given the billions of dollars paid in active management fees, logic tells us that it is impossible that both securities markets and asset management markets are perfectly efficient. If the securities markets are perfectly efficient, then it is inefficient to pay active managers.

Second, the market also cannot be highly inefficient, completely divorced from economic fundamentals. Why? Because many highly competitive investors try to beat the market, and their attempts to buy low and sell high tend to push prices toward fair value. As anyone who has tried beating the market knows well, success here is very difficult.

In reality, the market is just inefficient enough to allow skillful, hardworking active investors compensation for their efforts, costs and risks, but that’s the extent of the inefficiency. The market is just inefficient enough to reward skill, but efficient enough to discourage any more active investing than that.

Many things in life and nature are efficiently inefficient — a state that arises whenever you have competition under frictions. Consider, for instance, what happens when you drive on a busy highway. Should you stay in the same lane or switch to a different lane in an effort to save time? If the traffic is fully efficient, then all lanes are equally good, and, like passive investors in the markets, you might as well stay in your lane. But, if everyone drives passively, then what would make all lanes flow equally?

What actually happens is that some drivers attempt to switch to the best lane, thus moving traffic toward equal speeds across all lanes. The result is efficiently inefficient traffic. Those who dislike lane switching stay where they are, whereas those who want to be active — and are good at it — may benefit from doing so. This is analogous to active investors who switch from one stock to another to benefit from a change in market conditions. To push the analogy a step further, both frequent lane switching and high speed increase the risk of driving — so skill is required — just as frequent trading and high leverage increase an investor’s risk of poor performance in financial markets.

In traffic, you realize that how fast you get there is not just luck. To arrive faster, you need to monitor the traffic, navigate well and find a route or a time that is less traveled. In efficiently inefficient securities markets, to seek outperformance you need to monitor the financial data, transact at a low cost and find investment styles that are less crowded.

The idea that markets are efficiently inefficient can help explain why certain strategies have historically been successful and how investors like Warren Buffett made their fortune. For instance, value investing and trend following have historically performed well across markets — just as switching to a less-crowded lane when its speed increases may work in driving. The real world is efficiently inefficient. Understanding this will help you navigate.

Lasse Pedersen is a finance professor at Copenhagen Business School and New York University’s Stern School of Business and a principal at AQR Capital Management. His book, Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined, was published in April.

See also Institutional Investor’s March 2014 cover story, “ The Great Divide over Market Efficiency,” written by Clifford Asness and John Liew, Pedersen’s colleagues at AQR.