Unsophisticated investors harm market efficiency?

Discussion in 'Trading' started by fast, Sep 1, 2001.

  1. fast


    Here is a link to an article that reports on a recent speech delivered by Federal Reserve Vice Chair Roger Ferguson:


    According to the article,Ferguson discussed the role of information technology, saying that it has ... introduced the world of stocks and bonds to otherwise unsophisticated investors.

    The article states:
    "Ferguson agreed in spirit with a recently published position paper that suggests information technology's contribution to increased investment -- largely through the Internet -- has in turn harmed market efficiency since it introduces more and more unsophisticated investors into the market place.

    The paper cites, for example, the increased use of sometimes watered down pro forma corporate earnings numbers in the media as a means of weakening financial disclosure."

    :confused: I do not understand why the paper cites increased use of pro forma corporate earnings in media as an example of the way unsophisticated investors have harmed market efficiency. I thought pro forma earnings came about because someone (analysts? CEOs of new economy companies? investment bankers?) argued that old economy earnings formula did not fit new economy companies. But the article seems to imply that the pro forma approach was invented for unsophisticated investors. Do you agree this is implied by the article? And was the pro forma approach invented for naive investors?

    IMHO, at the very least, Wall Steet and corporate America should be given credit (blame?) for their role in inventing and promoting the pro forma earnings approach. It seems very hard to pin responsibility for the use of a very sophisticated (slick?) approach on a very unsophisticated group.

    Perhaps first we should discuss whether unsophisticated investors HAVE harmed market efficiency. Any thoughts on this?

    Note: I have not double-checked to see whether the author of this article accurately decribes the position paper -- not possible since the author did not identify the position paper.
  2. WarEagle

    WarEagle Moderator


    If a market is perfectly efficient, it is implied that all participants have equal and total information with regards to pertinent information about that market. So, if you argue that unsophisticated investors participate in the market without the same information that "sophisticated" participants do, then they may make decisions that would not promote market efficiency. In fact, as traders, we rely on inefficient market behavior and try to capitalize on it.

    The flaw here though is that many people, in particular academics, believe the market is very efficient, and in fact argue that traders cannot make above average returns. While I am not about to argue whether or not that is true, the fact remains that there are a lot of inefficiencies in the market, even with sophisticated participants. That is because it is almost impossible to know everything there is to know about a market (i.e. supply/demand, true earnings, etc.) So, I don't think the addition of unsophisticated participants will make that much of a difference. If they are unsophisticated for too long, they will be efficiently removed from the marketplace by the sophisticated. So, perhaps it is a self correcting problem. Survival of the fittest. The free market is such a great thing in that it needs very little outside influence to function properly. I'm always amazed that "smart" people believe they can somehow do a better job through various regulations in the name of protection or some other social agenda.

    But in the long run, I think the addition of new participants is good for the market due to added liquidity, which leads to a more efficient market. Just look at the shrinking spreads after the injection of EDAT traders into the marketplace, many of whom were "unsophisticated", particularly through the learning curve.

    I think I got a little off the original question...sorry, I just started typing and ended up with that...:)

  3. fast


    War Eagle,
    I admit I don't know much about this, but I thought the "efficient market" meant that all known information about a stock at any one point in time is reflected in the price of that stock, rather than that all participants have equal and total information about that market. I frequently see a stock's price move and know something has happened, and only later learn what happened. The price reflected known information before I personally knew what the info was. And I could make buy/sell decisions based on the stock's price movement without knowing the specific info.

    I agree that unsophisticated investors will be efficiently removed from the marketplace by the sophisticated, and I too am amazed that "smart" people believe they can somehow do a better job through various regulations.

    I started this thread because I think this article is evidence that key policymakers continue to be concerned about harmful influence on the market by non-professional investors. As long as this is true, additional restrictive regulations are a possiblity.:(
  4. roger2


    Regarding whether the unsophisticated investors increase market inefficiency - to a very small degree they may, IMO. Being vulnerable to manipulations of analysts, CNBC appearances by CEO's, etc. and possibly not understanding pro-forma earnings - reacting to things that more experienced investors may recognize as hype.

    But to me, a nominal increase in market inefficiency (if it does exist) is not the relevant question. The internet exists, should it be disabled? Brokers make it possible to buy/sell online, should that be illegal? All the components (which make it possible for ANYONE to easily participate in the markets) exist, having evolved naturally as a part of our technological evolutuion. The market has expanded to include a larger percentage of the 'less sophisticated' than previously was the case - but that's a fact and industry regulators should just accept it.

    To me the more important question is: Should regulators exercise authority, in the name of restoring efficiency to the markets, to exclude the 'less sophisticated' from the markets? Never. You shouldn't create a new law to try to fix everything you don't like.

    I like this excerpt from WarEagle: "The free market is such a great thing in that it needs very little outside influence to function properly. I'm always amazed that "smart" people believe they can somehow do a better job through various regulations in the name of protection or some other social agenda. "

    To go off topic myself, I think that this type of 'urge to control' is prevalent in every area. Our freedoms, all types of freedoms, are constantly being encroached upon by the "smart" people. Legislative bodies (and Commissions) at the fed/state/county/city levels meet regularly to create new laws - this practice is never questioned. How often do they scour through the books looking for unnecessary or no longer relevant laws which could be removed?
  5. Babak


    There are really 3 sections to the Efficient Market Theory (emphasis on theory ):

    weak form EMT-current prices reflect all market information (price, volume, all technical analysis inputs)

    semi-strong form EMT-the above + all public information (earnings, PE rations, dividends, cash flows, etc)

    strong form EMT-the above + all private information (no group of investors has an edge over others)

    So much research has been done re the above 3 and so many holes have been punched through the EMT that even its staunchest supporters admit that it looks like swiss cheese.

    My opinion is in total agreement with the article. It states:

    "The problem was not, for the most part, that new investors came to dominate the market, but that many investors' attitude toward and perception of risk changed markedly,"

    The key is to focus on the risk tolerance or psychological make-up of these 'unsophisticated' or new investors. Not simply the fact that they were new.

    The market is constantly in flux, new untrained investors coming in and wise speculators leaving. And vice versa. What we had in the recent past was a perception that things had changed in terms of risk/reward. It was this perception of 'easy money' lead many new investors into the market. The market is so large that it absorbed their participation, without any problem.

    Any inefficiencies caused by the entrance of new investors into the arena is quickly taken care of by the invisible market forces.

    We have to make the distinction that the reason why they participated in such large and unprecedented number was because of the perception of easy money caused by an extremely lax monetary policy stance by Greenspan.

    Also, when speaking of market inefficiency, you have to be aware of your time frame. Eventually (given enough time) the market is perfectly efficient. Look at Amazon.com for example. Looking back we can say that it should never have been trading so high. It doesn't make sense, there was no reason. Except emotions such as hope and greed.

    Such large (in terms of size) and long (in terms of time needed to correct) inefficiencies only occur due to a shift in sentiment. Another example is the tulip bubble that hit Netherlands long ago.

    Other inefficiencies (mispricings of options, for example) are taken care of much quicker. A specific community within the market makes this their daily bread and butter (arbitrage).

    My point (forgive the length of this) is that the specific inefficiency caused by a 'newbie' is solved rather quickly.

    While the other inefficiency is like a disease that can strike both a new unsophisticated investor and a person which we would assume should know much better (such as the manager of Munder Net-Net, or Janus 20, etc.) Their participation is necessary in this madness. They have the real weight in the market.
  6. WarEagle

    WarEagle Moderator

    Yes, Yes, Yes...excellent posts...all of you. This area has always fascinated me, because all of my college economics and finance professors told me I was crazy to want to trade. We debated the EMT ad nauseum until I finally gave up. I think, with the exception of Wet (he being the only one I know who trades), most college professors have a very low tolerance of risk so they buy into this theory without much question. So, they are right that in the so called "long run" the market is efficient like Babak said, but in the short term there are many temporary inefficiencies that can be exploited. It is this exploitation that causes the market to become efficient over the long run. This is the "invisible hand" of Adam Smith. I would argue that the very intervention of regulators to affect efficiency contributes more to inefficiency (through higher barriers to entry) than anything unsophisticated entrants cause.

    Sorry to sound like an economics class, but hey, I've got to use this degree on my wall for something! :)

  7. tradex21


    I suggest all of the posters read a book by George Soros entitled "The Alchemy of Finance", particularly Roger Ferguson of the Fed. This is tantamount to blaming the clerk at the 7/11 store who was shot and killed during a stickup attempt. Markets nor people can be totally efficient or perfect.:cool:
  8. Fohat


    the fact remains that there are a lot of inefficiencies in the market.

    Indeed. If markets were efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. Therefore the market is not perfectly efficient.

    Every discovered inefficiency is an opportunity to make a profit. Pro forma earnings was created and promoted by sophisticated investors, this inefficiency as any other will quickly disappear, because the market is a self correcting mechanism.

  9. I can just as easily say a 5 billion dollar mutual fund exiting or entering their position causes the market to not be efficient. There will be traders who take the other side of the funds position but they will do it at their price. This is how traders can profit..

  10. tntneo

    tntneo Moderator

    agreed !
    market efficiency theory is a joke. Certainly 12 months cycles are tradable profitably [and probably longer, but I am no expert on these longer time frames] this is possible because the market is not efficient.
    I believe the market is a chaotic fractal system, so inefficiencies in the short term implies inefficiencies at any time frame.
    It is even funny to discuss this, since thousands [thousands!] of traders for firms and institutions are using this 'efficient' market.

    a word back on the pro forma. it is a bit naive to think pro forma was used more and more to fool individual new investors. clearly it is used to fool institutions : they have the size to move markets. analysts can justify stupid decisions thanks to pro forma.

    probably the full circle is there : efficient or not, not everyone can win at the same time. and sometimes, yes, sometimes the majority loose together and at the same time.

    no, no, don't look at Japan and a 17 year low for the Nikkei.
    strange how the Nasdaq chart just like the Nikkei chart too.. :eek:

    #10     Sep 2, 2001