Evidence of Market Inefficiency
Daily stock market returns exhibit what is called a “random walk.” In mathematical terms, this
means that returns are not serially correlated — today’s returns do not predict tomorrow’s. If prices
were to exhibit positive serial correlation, when they rose or fell one day, they would tend to continue to rise or fall the next day. Negative serial correlation, also known as reversion to the mean,
would be just the opposite — today’s rising prices would lead to tomorrow’s falling prices, and viceversa.
A study entitled “Evidence on the Speed of Convergence to Market Efficiency” observed that, despite the lack of positive or negative serial correlation within daily market movements, it is a curious
fact that stocks held within the S&P 500 Index often experience persistent order imbalances, during
which purchase orders exceed or undershoot sell orders for many days at a stretch.1 One might
guess that such imbalances would lead to price momentum and thus a positive serial correlation, yet
daily returns remain random. If there were serial correlation, traders could profit from this information; they could buy or sell today, knowing that prices would be likely to continue to rise or fall
tomorrow. Yet we know it is very difficult (if not impossible) to profit from the knowledge of today’s returns.
The study’s authors explained this apparent anomaly of persistent purchase order imbalances, unaccompanied by momentum in price movement, by noting that trading activities in the middle of each
day are removing any market anomaly (inefficiency). They also analyzed how fast, and in what patterns the process happens. They found that it generally took just about 10 minutes for most of the
order imbalance information to be incorporated into prices. Within about 30 minutes there was no
longer any significant serial correlation to be exploited.2
Here is roughly how the process occurs. When an order imbalance develops, naïve traders assume
that a market inefficiency also exists and that prices will exhibit momentum. They thus jump on a
bandwagon that is probably heading nowhere, by assuming that the market will be slow to incorporate the new information. At the same time, the specialists on the floor have quickly reacted to the
initial order imbalance by altering prices more than necessary for long-term equilibrium. Finally, astute traders intervene with countervailing trades in the opposite direction. This arbitrage process
does take some time, but not very much.
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In a separate study, professors Bradford Cornell and Richard Roll hypothesized that efficient markets must be inhabited by both passive and active investors.3 The authors summarize as follows:
Some traders will expend resources in an effort to forecast prices [i.e., use an active
approach] and others will simply trade without any attempt at “analysis” [i.e., use a
passive approach]. Given information processing costs, a stable proportion of the
population will pursue each strategy. An economic equilibrium will result when the
expected payoffs to both strategies are equal and when no individual not already
trading has an incentive to begin with either strategy.4
In other words, active investors perceive enough benefit for their efforts to cover their expenses, on
the margin. The result is that active investors somehow move prices enough so that passive investors get a free ride simply by maintaining their long-term buy and hold approach.
There is an old joke about two economists walking down the street until one spots a $100 bill on the
sidewalk. The other says, “That cannot be a $100 bill. The market is too efficient and someone
would have already picked it up,” and they go on their way. The point is, there may be seemingly
“free” profits to be plucked off the pavement from time to time, even in a market filled with highly
trained specialists. However, the odds of running across such prizes remain so slim that one is better
off pursuing the majority of one’s wealth elsewhere.
1
2
3
4
Tarun Chordia, Richard Roll, and Avanidhar Subrahmanyam, Evidence on the Speed of Convergence to Market
Efficiency. August 31, 2001, http://www.anderson.ucla.edu/acad_unit/finance/wp/2001/11-01.pdf
Ibid.
Bradford Cornell and Richard Roll, Strategies for Pairwise Competitions in Markets and Organizations. The Bell
Journal of Economics, Spring 1981.
Ibid.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication
is for general information only and are not intended to serve as specific financial, accounting or tax advice. To be distributed only by a registered investment
advisor. Copyright © BAM Advisor Services, 2001.
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