[MUSIC] Learning outcomes. After watching this video, you will be able to, one, understand the meaning of market efficiency. >> Hello and welcome to this lecture on efficient markets and portfolio performance evaluation. So, the first idea we want to explore is the idea of market efficiency. What is efficiency? Efficiency here refers very specifically to informational efficiency. What is informational efficiency? It simply means how quickly does information get into the price of any asset? It doesn't have to be a stock, a bond. It could be any asset, right? So the idea is the more efficient the market is, the quicker prices react to new information. And this is a really important concept because there is a great controversy out there in economic finance. Especially we'll see this disagreement between academics and practitioners as to whether the market is efficient or not. Before we get on with the business of efficiency, let me also remind you that efficiency does not mean that at all times, price is equal to what one might call intrinsic value. All they're asking is, if there are any pricing errors, they should not be systematic. In other words, a market will not systematically underprice or overprice any asset, right? So with that introduction, let me talk a little bit about whether a market can be perfectly efficient. So of course, when you start thinking about efficiency, let's say in engineering, about an engine, all right, it is usual to conceive of an engine which is 100% efficient. Now, does this 100% efficient engine actually exist in the real world? The answer is no. But then why do we need that benchmark? Precisely because we will benchmark every real world engine to this 100% theoretically efficient engine. Similarly, people started asking a long time ago, is it true that a market can or will be perfectly efficient? That is 100%. And the answer is not really and here is an argument by Grossman and Stiglitz. Way back 1980, they said the following. They said, look, no market can be perfectly informationaly efficient and the reason is, the story that they sketched out in their paper which I'm going to tell you in a few points. Number one, there is tons of investors in the market. Broadly we can classify them into two kinds. One is informed, one is uninformed. In other words, the informed investor trades based on whatever information they uncover regarding a certain security or asset. Why do uninformed investors trade? Not for entertainment certainly, they trade for, for example, liquidity reasons. That is to say, they want to, for example, I'm putting my daughter through college, so I want to liquidate part of my portfolio. Now that has nothing to do with any information I might have about a particular part of my portfolio, I simply want money right? So, at that point I'm acting as an uninformed investor. Now, focus on the informed investors for a little bit. Now these guys work really, really hard to find mispricings in the market. Obviously, if they find that something is priced lower than it should be, they would like to buy, and vice versa. Now, where do they get this information? Well, they acquire it, and then they process it, right? And acquiring information as well as processing information is inherently a costly process, why? Because we need smart brains, and smart brains don't come cheap, right? So that is the basic idea, that information is costly to acquire as well as process. Now these guys get this information, process it from usable certain securities and place trades. Now, the point of the matter is, the more informed traders there are and the harder they work, the more difficult it is to find inefficiencies. So imagine there's a bunch of 500-rupee notes lying on the floor, right? Now, of course, this situation won't last very long because some of us smart people will quickly pick up the 500 rupee notes, and walk away. Now, the fact is, the more number of people there are searching for 500 rupee notes, the fewer 500 rupee notes you are likely to find lying on the ground. That is the idea here. So the very act of trying to utilize information to trade drives prices closer to value and that is really the idea of these informed traders making the market efficient. However let's say they make the market so efficient that it is 100% efficient. That is price equals value perfectly. What happens then? Then, the informed traders basically see there is no return to debt acquisition and processing information because they have no advantage over anybody else in the market. So at that point what happens, well, they move on to other places. And they say, I am going to look for the inefficiency there or here. But, then the moment these guys walk out the door and go to some other market, what happens is, now this market itself paradoxically becomes again a little inefficient and then more inefficient, right? So, now the point to note here is, what is going to happen now? Again people are going to enter this market in the hope of making money. So this is a vicious cycle right? It is a state of disequilibrium which can only be broken in one way, right? Mathematically and logically, right? And the way to break this cycle is to think of a market as being efficient only to the extent that the marginal trader recoups his or her cost. So that is really the idea of Grossman and Stiglitz. Now of course, this is an old argument, but I want really pick on a couple of implications of their argument. Number one, since there's lots and lots of investors who are looking for inefficiencies and this we can see all around us. There's lots and lots of market participants. They're all there to make money. So you can be sure that there are many, many investors looking for these mis-pricings or inefficiencies. Which means that finding the probability of finding easy money opportunities is probably not going to be there. Which simply means that markets will be largely efficient, to a large degree, is what we're saying. Number two if there is a certain market where the cost of exploiting efficiency is higher. For example information acquisition costs are higher or maybe smart MBA students are in short supply. In these cases when cost of finding these pricing is actually going to go up. Well, naturally you are more likely to find inefficiency synthesisely those market. In other words, what we are saying is not that nobody can make money. If you are better than me marginally at acquiring slash processing information. You can make a little more money than I can. So you, if you're the marginal investor, you will make money to the extent that you recoup your costs, that's the idea here. Finally, the degree of inefficiency in any market. And when I say market, I don't mean geography, I mean any asset market will depend upon the number of informed investors who are around who are closely looking to exploit opportunities. So that's really the story of Grossman and Stiglitz.
