Market efficiency is the idea that market prices reflect all the available information. If a market is efficient, then that means all the information is already reflected in the price. So there should be no way to beat the market because there's no over price to underprice securities. This was an idea that was developed by the economist Eugene fama in 1970. And he called this idea the big title of the efficient market hypothesis. And the idea is that you should stick your money in passively managed funds, index funds that just track the overall market, rather than sticking your money in a actively managed fund where people are selecting which stocks to pick.
Because those people actually aren't picking any better than just a random index. There's a few proponents of efficiency. Lucas Roth, a professor of economics So let's say markets were efficient. And someone came up with a strategy of guaranteed profits by doing this x strategy, whatever it is, well, other people are going to notice. And as soon as they notice that this strategy is being used, they're going to copy it. They're going to jump aboard and do the same thing until profits disappear.
So as soon as people realize they're being modeled, the profit will go away, and the market will return to being efficient. Lucas Roth is an interesting fellow, actually, he his wife. When he got married, she wrote into the marriage agreement that if Lucas Roth ever won the Nobel Prize, she would get half. Well, a few years later, they got divorced. But Lucas Roth won the Nobel Prize, so she got half of the money. So here's the reasons for market efficiency.
Often they point at how mutual funds hedge funds and pension funds They often don't outperform the market or an index that the whole market. If you were just randomly selecting stocks and throwing that into portfolio, often that does better than fundamental or technical analysis, which is bad for me when I'm doing fundamental analysis essentially the saying I'm wrong. Jacob Bernoulli points at the law of large numbers, where he says the average of a large number of guesses is more accurate than an individual. The average market decision is actually a better predictor than any one person. James shore wiki is a professional who likes to experiment with students in this class, and he has a jar of jelly beans in front of the class that he then gets all of his students to make a guess of how many jelly beans are in this jar. And if the students are able to guess correctly, the student wins in a bottle of expensive wine but The professor, what he does is he takes the average of all of the guesses of the students in the class.
And if that guess, is closer than any individual student gets, then the professor just keeps the one professor who has never had to give out the one. Lawrence Henry summers says that that doesn't actually mean much, though. Hedge Funds mutual funds and pension funds Apple not outperforming the market, that doesn't actually mean that the market is efficient. What we have is evidence that investors don't beat the market. But that doesn't mean necessarily that the market is efficient. There's a few other arguments.
So Simon Herbert and Joseph Stiglitz, they focus on these ideas of how if you were to invest more and more money, to learn more information about securities, there's going to be a certain point with the benefit is going to be less than the cost of getting more information. So there's actually some kind of equilibrium there where people are going to keep seeking out more information about securities until it's no longer beneficial. But people don't often think in these terms, especially not investors to not thinking about how much does it cost to get this information versus how much profit Am I gonna get. Myron Scholz and Fischer black argue that if markets are inefficient, then there would be no arbitrageurs. arbitrage in this definition, is referring to the idea that you can buy security at a price that is different than the value of the security. So over time, that stock should in an efficient market return to the correct value of that security.
And they're saying that if markets are inefficient, that security will never return to the correct value. So, if a market is inefficient, there would be no arbitrators. Andre Schieffer point out that this doesn't actually seem to be the case. So we don't see large arbitrage positions. So why would this be? Well, there's a few reasons.
In order to take a large arbitrage position, you have under diversified risk, you have holding period risk, which means you have mispricing that might be getting worse before it gets better. Also, you might have contractual problems such as you might borrow, but if it takes too long, then investors are going to want their money back. And that you might be able to not capitalize on your arbitrage position before investors want their money back. Charles Lee Andre Schieffer and Richard Taylor, they point out that there's a lot of evidence for market inefficiency. And what they point at as their examples is looking at closed end funds. This is where you have a fund that the only purpose To invest in other companies shares.
So in theory, the value of the share holdings should be the price, you should have the same price as the value of the share holdings minus the management costs, there shouldn't be any deviation between the price and the actual value of those securities. What we find is this doesn't happen to reality. So investors are in this case irrational. Otherwise, it would make sense that the overall funding price of a closed end fund has to be just noise. It has to be randomness, it doesn't make any sense because you're buying something for a different price than its value. Here's another example.
When a stock gets added to the s&p index, the value of that stock isn't actually changing. But we find that the stock price changes just because it was added to the index. The value is the same though Even more interestingly, is that this happens not on the announcement day. But on the day that is added to the index. Really, it should be on the announcement day that we say that the stock is going to be added to the s&p index. If you want to read more about stuff like this, you can check out the book by Andre Schleper, which is called inefficient markets and introduction to behavioral finance, extraordinary popular delusions and the madness of the crowds.
In 1600s, there was something called tulip mania, where people for some reason decided that tulips were worth a lot of money, and people would pay a lot of money, the tulips. I guess this is similar to what we experienced in these last few years over Bitcoin and other cryptocurrency where we just decide this thing has money for some reason. Anyways, so people essentially they started purchasing futures contracts on tulips and at a certain point someone defaulted on these futures contracts on tulips and the market completely collapsed. The Dutch government then had to step in and honor two contracts at 10% face value. And remember, we're just talking about flowers here. It's just the tulip.
The South Seas company was a scam, you want to be Hudson's Bay Company. And they claimed to have a perpetual motion machine. Isaac Newton was around this time. And he was curious about this perpetual motion machine. That's interesting. So he's stuck some money in there.
And then he realized that this is completely against physics. So this is impossible. So he took his money out, but then he noticed the company kept going up in price, people still kept investing in it. So he thought, well, geez, if they're investing in it, I may as well. So he stuck his money into this company talking about a perpetual motion machine, which he knew was garbage. But he did it anyways because The price kept going up.
And of course, the SE company went bankrupt at a certain point and Isaac Newton lost all of his money. JOHN law created the Mississippi company, which was a company that had a trade monopoly granted by the French, on the condition that john la would pay off France's national debt. While he did this, and he raised stock prices to extremely high heights, just using complete bogus rumors, talking about how there was Cities of Gold. If you've seen the movie Eldorado, you'll know what they're talking about all of these ideas of these places of wealth somewhere in the world. Anyways, the stock eventually collapsed and john Locke disappeared. So here's the cycle that we see when we're talking about a stock crash.
Here's the steps that we often find. First of all, there's an expansion of credit. There's deregulation, and this allows people to fund entrepreneurs with their crazy, wild, innovative ideas, then there's a lot of overtrading is high leverage, the speculation is boring at high interest rates, because it makes more sense to ball and stick your money in a stock and get higher returns and then use that high return to pay back the interest of your borrowing. So you see a lot of high borrowing. Then you have some mania, where people just assume profits are going to increase forever. And this is where scams and frauds Start to begin, but people don't notice and cash just keep pouring in even though the opportunities are getting smaller and smaller.
And then at a certain point, the bubble pops when people realize that something is odd, and we often claim this event caused the whole crash. But really, this bubbles been building up for a while. Then there's some panic. And people start to analyze the market and analyze stocks. And they realize that there's some significant problems here. There's a lot of negative views, all the scams and frauds, they start to come unraveled, and everyone tries to exit the market at once.
And that's when you have to crash. Then there's a collapse. Often there's an overreaction and companies go bankrupt. People are unable to get funding for reinvestment and taxpayers and voters they start demanding regulation, often over regulation. Here's a few examples when I mean by scams or frauds, in 1920, Charles Ponzi, he took money from investors, he bought stuff for himself, and then use some of that money to pay investors and claimed that his company was actually making the money rather than just passing the money from one investor to the other. There's other exotic Such as Bernie Madoff and Gary Sorensen.
They did this exact same approach. But people fell for it. And the market wasn't able to realize that this was a scam until it was too late. So, here's the real question are markets efficient? In theory, they should be. But in practice, we find tons of examples showing that they are inefficient.