The Wall Street Journal
Thursday, December 28, 2000
Are Markets Efficient?
No, Arbitrage Is Inherently Risky
By Andrei Shleifer
The extraordinary performance of the stock market until recent months has led
many skeptics—from Federal Reserve Chairman Alan Greenspan to bestselling
economist Robert Shiller—to complain about irrational exuberance. Market enthusiasts
have responded by pointing to the efficient markets theory, which holds that the market is
far better equipped to assess the prospects of American companies than any pundit.
The idea that “the market knows best” was developed at the University of
Chicago in the 1960s. It was gained enormous intellectual dominance since then and is
now drilled into the head of tens of thousands of business students around the world. Yet
a growing number of economists, myself included, are of the belief that because arbitrage
is risky business, markets are necessarily inefficient.
The efficient markets theory holds that the trading by investors in a free and
competitive market drives security prices to their true “fundamental” values. The market
can better assess what a stock or a bond is worth than any individual trader. If the stock
market is efficient, we don’t need to worry about irrational exuberance or a crash, and we
don’t need to make up stories to explain the New Economy. But if the market isn’t
efficient, we are in for a meltdown, or at least a long period of mediocre returns.
Perhaps the most compelling evidence in favor of market efficiency is the
inability of even the shrewdest investors to consistently beat the market. It isn’t just that
individual investors trail the passive benchmarks, such as the Standard & Poor’s 500, by
2% to 3% a year. Nearly all mutual and pension funds also fail to beat the market on a
consistent basis. Even the savviest investors—George Soros, Warren Buffett, Julian
Robertson—occasionally stumble. If markets were irrational, the argument goes, then the
very best investors would find strategies to make money consistently and without risk.
The fact that they do stumble proves that the market truly knows best.
This last argument—that even the best managers aren’t able to outsmart the
market—is the most plausible, and has become the bedrock of the efficient market
theory. Unfortunately, it is false, and for a very simple reason. In financial markets, bets
against security mispricing, sometimes referred to as arbitrage, are bets that prices will
converge to true values. With rare exceptions, such bets are inherently risky.
An overpriced stock today can become even more overprices tomorrow, bringing
losses to even the cleverest short-seller. A bargain today can become an even better
bargain next month, bringing grief to a value investor. Even the shrewdest investors must
bear these risks and so lose money on occasion. Some of the risks they face can be
hedged, but many can’t. Because rational arbitrage is always risky, it is inherently
limited in its ability to bring prices to their true values. A free, competitive market is
almost necessarily inefficient.
To illustrate this point, consider how efficient markets theory goes wrong. One
very clear example is the pricing of the shares of Royal Dutch and Shell. Royal Dutch
and Shell are independently incorporated in the Netherlands and England, respectively.
In 1907, they formed an alliance agreeing to merge their interests on a 60-40 basis while
remaining separate and distinct entities. All their profits, adjusting for corporate taxes
and control rights, are effectively split into these proportions.
Information clarifying the linkages between the two companies is widely
available. This makes for an easy prediction for the efficient markets theory: If prices are
right, the market value of Royal Dutch should always equal 1.5 times the market value of
Shell. In this case, the efficient markets theory reflects the law of one price: Identical
securities must sell at the same price in different markets. If not, there would be clear
and easy arbitrage opportunities from dumping the relatively expensive stock and buying
the cheaper one.
The nearby chart shows the deviations of market values of Royal Dutch and Shell
from the 60-40 parity from 1990 to 1999. In the early 1990s, Royal Dutch traded at a 5%
to 7% discount from parity, while in the late 1990s it traded at up to a 20% premium. A
closer look at the chart clarifies why the market doesn’t bring the relative prices to
A shrewd investor who noticed, for example, that in the summer of 1997, Royal
Dutch traded at an 8% to 10% premium relative to Shell, would have sold short the
expensive Royal Dutch shares and hedged his position with the cheaper Shell shares.
Sadly for this investor, the deviation from the 60-40 parity only widened in 1998,
reaching nearly 20% in the autumn crisis. This bet against market inefficiency lost
money, and a lot of money if leveraged.
In this case, it is said that when Long Term Capital Management collapsed during
the Russian crisis, it unwound a large position in the Royal Dutch and Shell trade. Smart
investors can lose a lot of money at the times when an inefficient market becomes even
less efficient. In fact, as the LTCM experience illustrates, their businesses might not
survive long enough to see markets return to efficiency.
The inefficiency in the pricing of Royal Dutch and Shell is a fantastic
embarrassment for the efficient markets hypothesis because the setting is the best case for
that theory. The same cash flows should sell for the same price in different markets. It
shows that deviations from efficiency can be large and persistent, especially with no
catalysts to bring markets back to efficiency. It also shows that market forces need not be
strong enough to get prices in line even when many risks can be hedged, and that rational
and sophisticated investors can lose money along the way, as mispricing deepens.
But if markets fail to achieve efficiency in this near-textbook case, what should
we expect in more complicated situations, when the risks of arbitrage are greater? Who
would dare to sell short Internet stock to bring their prices down to earth when a company
trading at five times its fundamental value can easily rise to 10 times its value? Or who
would bet against the overpriced S&P 500 as a whole? What would have happened to the
seller of the market who heeded Alan Greenspan’s concerns in 1996?
If smart investors lose money whenever markets move away from efficiency, it is
not puzzle that even the mightiest stumble. On average, they make money (the track
records of Messrs. Soros, Buffett and Robertson are nothing to complain about) but the
money they make is not without risk. The fact that arbitrage is risky in no way implies
that the market knows best. To the contrary, it shows that a misvalued market can
become even more misvalued. As the great financial economist Fischer Black once
wrote humorously, the market is “efficient” when security prices are within a factor of
two from value.
In inefficient markets, active investment management pays off in the long run.
Contrarian strategies—betting against the mispricing—do better over the longterm than
indexation. Value stocks have in fact outperformed growth stocks over long periods in
the U.S. and European markets. But these strategies are inherently risky precisely
because markets can move further away from efficiency. The Internet bubble of 1998-99
killed the relative performance of value investors; Mr. Robertson was only one of the
victims. The question for active investors is whether they can take the pain of volatility
long enough before the bubble bursts.
Market Knows Better
The fact that markets aren’t efficient doesn’t imply that the government should
regulate them. Far from it. There are many benefits of inefficient markets. There are
many benefits of inefficient markets. The Internet boom would not have been possible—
at least not on the same scale—without financing from irrationally exuberant investors.
The millions of Americans now benefiting from stocks might have stuck with savings
accounts without the boom. The proposals to reform Social Security—both Democratic
and Republican—would not have even started if markets were moribund. Yet to keep the
government away from markets, we do not need to proclaim that “markets know best.”
The weaker but more accurate proposition, that the market knows better than the
government, is more than sufficient.
Mr. Shleifer is an economics professor at
Harvard and author of “Inefficient Markets”
(Oxford University Press, 2000).
Yes, Even if They Make Errors
By Burton G. Malkiel
There is an old story about a finance professor and a student who come upon a
$100 bill lying on the ground. The student stoops to pick it up. “Don’t bother,” the
professor admonishes. “If it were really a $100 bill, it wouldn’t be there.”
This story illustrates what financial economists mean by efficient markets.
Markets can be efficient even if investors are subject to overconfidence and errors in
judgement. Markets can be efficient even if they make errors in the valuation of
individual stocks and exhibit greater volatility than can apparently be explained by
fundamentals such as earnings and dividends.
Many of us economists who believe in this efficient market theory do so because
we view markets as amazingly successful devices for reflecting new information rapidly
and, for the most part, accurately. Above all, we believe that financial markets are
efficient because they don’t allow investors to earn above-average returns without taking
above-average risks. In short, we believe that $100 bills are not lying around for the
While the efficient market theory has been the mantra of my generation, it has
come under increasing attack from a new breed of economists. Their work has
emphasized psychological and behavioral elements of stock-price determination; they
believe future stock prices are somewhat predictable on the basis of past stock-price
patterns and certain “fundamental” valuation metrics.
In their view, value stocks—those with low ratios of stock prices to earnings and
book values—are alleged to outperform growth stocks, while small-company stocks
supposedly do better than large-capitalization stocks. They believe that stock prices
sometimes underreact to news, creating some short-run momentum, as well as sometimes
overreact to events, creating price reversals that can be exploited by investors.
Behavioralists also emphasize that the arbitrage activities of rational professional
investors, who might be expected to bring stock prices back to fundamental values, are
often impossible to execute and, in any event, risky and therefore limited.
These attacks on the efficient market theory are far from convincing. Some of the
market patterns discovered may have rational causes; others may be spurious. But none
of them are dependable in all time periods. And there is no evidence that rational
investors can exploit any of the alleged mispricing in securities markets to earn above-
Many of the statistical patterns behaviorists emphasize could have rational as well
as psychological explanations. Some long-run evidence suggests that growth stocks
produce lower returns than value stocks. Behavioralists argue that this reflects investor
overconfidence about optimistic growth forecasts and overpricing of growth stocks. But
it is also possible that stocks selling at low valuations relative to their book values reflect
some degree of financial distress and riskiness, so they should offer higher rates of return.
Behavioralists also believe stock prices exhibit reversals because individuals
overreact to recent events. But reversals for the market as a whole could be caused by the
tendency of interest rates and risk perceptions to fluctuate, meaning that stock prices are
simply rationally adjusting to underlying economic conditions.
Many of the predictable patterns behaviorists claim to find in stock prices may be
the result of endlessly mining the vast financial data banks now available until they cough
up some seemingly significant, but wholly spurious, relationship. Moreover, findings of
underreaction appear in the data about as frequently as overreaction and so could be
random occurrences consistent with market efficiency. Many supposedly exploitable
price patterns tend to become marginal or even disappear when alternative measurement
approaches are used.
Even the strongest empirical regularities in the stock market aren’t dependable.
For example, small-cap stocks have historically outperformed large-cap stocks, while
value stocks have outperformed growth stocks. But investors acting on that finding
would have suffered very disappointing investment results indeed over this past decade of
And what of the behavioral tenet that when psychological contagion pushes price-
earnings ratios well above, and dividend yields well below, their historical averages, poor
investment results must follow? An investor who followed that advice would have sold
out in the mid-1990s when the stock market was less than half its present value. While
the “Dogs of the Dow” strategy of buying the depressed highest dividend yields in the
Dow worked brilliantly in back tests, when mutual funds were recently introduced based
on that technique that dogs didn’t hunt.
Finally, even if systematic pricing patterns persist over time, it may be impossible
to exploit them. One pattern my colleagues at Princeton and I attempted to exploit was
the overreaction phenomenon leading to return reversals. We simulated a strategy of
buying those stocks with the poorest three- to five-year performance (the winners). We
found that statistical patterns of return reversals held up and were strongly significant:
The losers later enjoyed better performance and the winners performed more poorly.
What the losers did not produce, however, were excess returns: The returns for both
groups were the same. There was statistical evidence of mean reversion but no
inefficiency that could be exploited for gain.
As Richard Roll, a brilliant financial economist and active money manager, has
said, “I have personally tried to invest money, my client’s and my own, in every single
anomaly and predictive result that academics have dreamed up. And I have yet to make a
nickel on any of these supposed market inefficiencies. An inefficiency ought to be an
exploitable opportunity. If there’s nothing investors can exploit in a systematic way, time
and time out, then it’s very hard to say that information is not being properly incorporated
into stock prices. Real money investment strategies don’t produce the results that
academic papers say they should.”
As further evidence of how difficult it is to outguess the collective wisdom of the
market, consider the relative performance of index funds (that simply buy and hold the
entire market portfolio) and active mutual-fund managers. While more than half the
active managers are beating the indexes so far in 2000, the long-run results are
devastating. Over the past three-year, five-year and 10-year periods, more than 75% of
active managers underperformed index funds when both are measure after expenses.
Those that do outperform in one period are not typically the ones who outperform in the
There are some exceptions like Peter Lynch and Warren Buffett, but you can
count the truly outstanding long-term overachievers on the fingers of one hand. If
markets were nearly as inefficient as some would believe, it would be easier for well paid
professionals to profit at the expense of those who make systematic mistakes in
processing information. As Rex Sinquefield, co-author of a thorough compendium of
past stock returns, has said: “There are three classes of people who don’t think markets
work: the Cubans, the North Koreans and active money managers.”
To be sure, we sometimes know in advance of isolated instances of mispricing.
My favorite this year occurred when 5% if Palm Pilot shares were spun off by its parent
3Com, which retained the other 95%. The market immediately priced Palm Pilot shares
at a valuation that made 3Com’s ownership interest “worth” more than $50 billion, much
more than the entire $28 billion market capitalization of the parent company. It was as if
the operational component of 3Com had a negative value. The mispricing persisted for a
while because not enough Palm Pilot shares were available for borrowing to effect a
profitable arbitrage. But over time, and with more Palm shares available, the mispricing
was corrected. The story illustrates that even occasional irrationality in market prices
doesn’t create a profitable trading opportunity.
In summary, I remain skeptical that markets are systematically irrational and that
knowledge of such irrationalities can lead to profitable trading strategies. Indeed, the
more potentially profitable a discoverable pattern is, the less likely it is to survive. This
is the logical reason one should be cautious not to overemphasize apparent departures
It is always possible that new patterns will emerge and be discovered, but such
patterns must be exploited immediately because they are unlikely to last. The advice I
give my student is slightly different from that of the finance professor of the story: “If
you see a $100 bill on the ground, pick it up right away because it surely won’t be there
Mr. Malkiel is the author of “A Random Walk
Down Wall Street.” He is a director of the
Vanguard Group and of the American Stock