Are Markets really efficient? And why should they be so?

Are Markets really efficient? And why should they be so?

By Mat Videos | PhilosoFinance | 12 Nov 2021


Whenever we suppose that markets are truly efficient, we imply that any result from portfolio management (profit / loss) is random. In other words, if all risks and potentials are perfectly priced by the market, it's impossible to create an edge, since all risk-adjusted expected returns would be equal.

The first element to consider is the existence of friction in markets. Starting, for example, with transaction fees. Nowadays, a big amount of transactions are processed via credit card companies who charge at least a 1% fee. Main cryptocurrencies exchanges charge at least 0.1% on spot transactions, which diminishes the set of potential arbitrages. Along with transaction fees, there are counterparty risks, not really easy to measure, and frequently associated with asymmetric information (on the trustworthiness of each player), which is another inefficiency generator. Moreover, several biases make people decide in non-optimal ways.

What can we expect about the evolution of such inefficiencies? How have they evolved in recent times? At first, in emergent markets (e.g. Brazil), we (finally) observe a desire of a bigger portion of the population to better understand financial markets. After the economic crisis generated by COVID-19 (and intensified by several political incertitudes), many people started to see in Finance a possible path to get richer, to escape those systematic problems. This is positive in terms of market efficiency since it reduces the information asymmetry concerning all other world citizens (and companies; more generally, investors) who already know such basic information. Some big financial education platforms such as Finclass (inspired by American similar services) make such basic information more accessible to their clients about finance: it's a cheap product ($6 per month), aiming for massive education, bringing a positive total effect because it reaches a big audience.

Regarding the market frictions, the main point is to systematically reduce transaction fees. With examples such as Solana, Fantom, and Polygon, the cryptocurrency world already showed that financial transactions can be cheap, even with the advantages of decentralization and trustworthiness (of smart contracts). It's natural that, over the long term, enterprises/blockchains offering the best solutions (in terms of price, scalability, security, and decentralization) will attract more people. With more and more competitors to process financial transactions, their edge starts to get smaller, which encourages them even more to pursuit their system's development. From all of that, we observe that the creation of more and more exchanges is positive to the market.

It's necessary to note that, with more exchanges, we can also expect more transactions and thus more data to be treated since there will have more activities to avoid arbitrage among them. But, as far as each exchange is capable of handling their data and being profitable, this one seems to be the optimal market solution to transaction frictions. Moreover, we must pay attention to whether environmental and social aspects are being duly considered (in the form of Pigouvian taxes, for example), to be sure that we will not be paying expensive environmental costs because of the multiplication of transactions and financial systems.

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For the upcoming discussion, it's important to bear in mind that money is a measure of value: someone's salary is a measure of the amount of value their job brings to society. Same for an enterprise's profit. This measure is unfortunately imperfect, due to supply/demand price distortions. However, there is a clear positive correlation between money and value.

If we believe in the Efficient Markets Hypothesis, we believe in particular that wealth is not capable of systematically reproducing itself. This, in relative terms: the proportion of all the world's wealth detained by an investor would be constant (have a constant expected value regardless of the allocating strategy). As a consequence, any individual could maintain their living standards only for a finite amount of time. To do so while preserving their wealth, it would be necessary to keep working and somehow bring more value to humanity.

This observation relates to the idea that it's not natural to have a perspective of early retirement, that a long-lasting and more enjoyable job would be a better solution to improving one's life quality (in terms of happiness). Thus, a greater level of market efficiency would mean a smaller capacity for wealth appreciation, which would make some rich people be (professionally) active for more time. In general, due to the neurological and psychological mechanisms attaching happiness and job satisfaction, retired (or simply unemployed) people not earning a sufficient amount of money to afford their living standards will have more natural incentives to go back to work and construct more value to humanity.

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A final personal opinion: a bigger market efficiency includes the systematic imposition of Pigouvian taxes and the development of quantitative finance. The first ones assure the efficiency of addressing market externalities, especially the ones regarding environmental issues, so important to our future well-being. Quantitative finance is incorporating as much data as possible into the market, via the transactions they decide to do. It's true that hedge fund quantitative managers exist mainly because of market inefficiencies, but something we can expect is that such companies (the quant hedge funds, but also QIS departments of banks) will "get paid to reduce inefficiencies", and that their investors will receive some kind of premium related to the doubt if there are or not sufficient inefficiencies so that the money placements specified by the managers will really be profitable. Thus, "quant hedge fund investing" will be simply another risk-adjusted equivalent investment form (in a sort of "efficient equilibrium"), but having the power of reducing market inefficiencies.

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PhilosoFinance
PhilosoFinance

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