What’s Wrong With Arbitrage?
EMH predicts that prices reflect fundamental value. Why?
People are greedy, and any mispricings are immediately corrected by arbitragers. But in the real world, true arbitrage—profits earned with zero risk after all possible costs—rarely, if ever, exist. Most arbitragelike trades involve some form of cost or risk.
This could mean fundamental or basis risk, transaction costs or noise-trader risk.
- Oranges in Florida cost $1 per orange.
- Oranges in California cost $2 per orange.
- The fundamental value of an orange is $1 (assumption for the example).
- EMH suggests arbitragers will buy oranges in Florida and sell oranges in California until California oranges drop to $1. Prices will quickly correct and there is no free lunch.
- But what if it costs $1 to ship oranges from Florida to California? Prices are decidedly not correct—the fundamental value of an orange is $1. But there is also not a free lunch.
Next, a discussion of psychology is in order. First, the literature from psychology makes it fairly clear that humans are not 100 percent rational all the time.
Daniel Kahneman tells a story of two modes of thinking: system 1 and system 2. System 1 is an efficient heuristics-based decision-making component of the human brain. System 2 is the analytic and calculated portion of the brain—~100 percent rational.
As stand-alone topics, limits of arbitrage and psychology are interesting, but they have limited potential to affect prices via their individual influences. However, crafting a hypothesis that involves elements of silly investors and market frictions—simultaneously—is a potent combination.
For example, consider the concept of noise traders. J. Bradford De Long, Andrei Shleifer, Larry Summers and Robert J. Waldmann wrote an article called, “Noise Trader Risk in Financial Markets” in the Journal of Political Economy in 1990.
Here is the abstract from the paper:
“We present a simple overlapping-generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.”
Combining biased investors with an understanding of market frictions/incentives can create powerful investment concepts. This combination can also describe what behavioral finance is all about; namely, understanding how behavioral bias—in conjunction with market frictions—create interesting impacts on market prices.
Wesley R. Gray, Ph.D., is the chief investment officer for Alpha Architect (AlphaArchitect.com), a systematic asset manager based near Philadelphia, Pennsylvania.