Grasping Reality on TypePad, by Brad DeLong

Brayden King asks:

Pub Sociology: A sociology of market efficiency: According to orthodox views of market efficiency, smart money should be able to correct for the irrationality of bad investors, bringing prices back to fundamentals even when the majority of investors over- or undervalue certain stocks. This is the role of arbitrage. Yet, we often see that markets still produce inefficient outcomes. Why?... Our sociological intuition tells us that market structure - the social relations between actors, practices, and meaning - ought to mediate the extent to which markets operate more or less efficiently. This is one of the most important insights that economic sociology has to offer, I think (and one of the primary conclusions in my dissertation). We should be able to show that the structure of relations in a market has a real impact on the efficiency of market pricing and choice.

Ezra Zuckerman, who I think is one of the brightest and most interesting scholars in the field, has a lot to say about this. In his 2004 piece* on structural coherence and market valuation, he argues the very this very point:

I challenge the assumption made by the [efficient market hypothesis] that the social structural environment typical of financial markets always has the necessary features to support the highly sophisticated social learning necessary for incorrect models to valuation to be driven from the market...

*Zuckerman, Ezra. 2004. “Structural Incoherence and Stock Market Activity.” American Sociological Review 69: 405-32.

Well, it is explicit in DeLong, Shleifer, Summers, and Waldmann (1990), "Noise Trader Risk in Financial Markets," Journal of Political Economy, that as a matter of economic theory rational, sophisticated investors are not guaranteed to earn higher expected returns on their portfolios than are noise traders if rational investors have short horizons, and if noise traders on average concentrate their long positions in the assets about which their opinions irrationally fluctuate.

It is implicit in DSSW (1990) that as a matter of economic theory incorrect models of valuation are not only not driven from the market but exist happily in it and can come to dominate it if:

1. Rational investors have short horizons.
2. Rational investors are risk averse.
3. Noise traders on average concentrate their long positions in the assets about which their opinions irrationally fluctuate.
4. Noise traders' misperceptions are correlated across noise traders.
5. New entrants into the market look back at recent realized returns to decide what valuation strategies to adopt.
6. There is enough fundamental risk to curb rational investors' willingness to take large positions against noise traders.

Perhaps it is time to make this explicit as well: here's a memo.

And I am still waiting for my copy of Braydon King's dissertation...