Investors feel the pain from inefficient markets and crazy behaviour

I have stood here before inside the pouring rainWith the world turning circles running ’round my brainI guess I’m always hoping that you’ll end this reignBut it’s my destiny to be the king of pain —King of Pain by The Police

This may seem strange coming from me, a quant geek who uses data, technology, and machine learning to develop and manage investment strategies, but here it is: I believe that technology has made markets less efficient.

Perfect efficiency, whereby prices are always “correct,” is like the tooth fairy: it is purely fictional. This divide between the ivory tower and the “real world” was epitomized by the legendary economist Fischer Black. After moving from the Massachusetts Institute of Technology to Wall Street, Black remarked, “Markets look a lot less efficient from the banks of the Hudson than the banks of the Charles.”

Bubbles and efficient markets: Fundamentally irreconcilable

Over the past several decades, markets have borne witness to two extreme bubbles:

How is it that markets experienced such extreme aberrations? I’m not sure that “crazy” is the right word, but I’m darn sure that it’s not “efficient.”

Without a doubt, periodic bubbles can be attributed to recency bias, a common behavioural quirk where investors favour recent information and events at the expense of considering objective facts and probabilities. This can cause people to chase recent winners and push their prices to unsustainable levels. As famed economist John Kenneth Galbraith wrote, “There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Recency bias notwithstanding, I believe there are other factors at play that are contributing to irrational behaviour and resulting in decreased market efficiency.

The wise crowd versus the foolish herd

Market manias and the related mispricing of assets seems paradoxical given the amount and speed of information that has become widely available over the past 20 years. However, speed and availability of information is a double-edged sword.