Friday, October 3, 2008

A more important reason for market ineficiency that I had not seen in the literature, at least explicitly, until my Economists' Voice letter

With regard to Berkley economist Hal Varian's March 10, 2005 article, "Five Years After Nasdaq Hit Its Peak, Some Lessons Learned", featured today by Mark Thoma, a bigger reason why a minority of well informed and expert investors often can't push stock prices very close to efficiency is the reason I gave in my 2006 letter published in the Berkley journal, Economists' Voice:

...One reason which was missing, at least explicitly, and which I have not seen yet in the literature, at least explicitly, is that a smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level.