Limits of Arbitrage

Arbitrage may not work when the costs outweigh the benefits. Investment costs include transaction costs, such as brokers’ fees, and risk, especially market risk.

An investor who sees an arbitrage opportunity would have to act quickly to take advantage of it, because chances are good that someone else will and the advantage will disappear along with the arbitrage opportunity. Acting quickly may involve borrowing if liquid funds are not available to invest. For this reason, transaction costs for arbitrage trades are likely to be higher (because they are likely to include interest), and if the costs are higher than the benefits, the market will not be corrected.

The risk of arbitrage is that the investor rather than the market is mispricing stocks. In other words, arbitrageurs assume that the current valuation for an asset will reverse—will go down if the valuation has gone too high, or will go up if the valuation has gone too low. If their analysis of fundamental value is incorrect, the market correction may not occur as predicted, and neither will their gains.

Most arbitrageurs are professional wealth managers. They invest for very wealthy clients with a large asset base and very high tolerance for risk. Arbitrage is usually not a sound practice for individual investors.

Causes of Market Inefficiency

Market inefficiencies can persist when they go undiscovered or when they seem rational. Economic historians point out that while every asset “bubble” is in some ways unique, there are common economic factors at work.Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes, 5th ed. (Hoboken, NJ: John Wiley & Sons, Inc., 2005). Bubbles are accompanied by lower interest rates, increased use of debt financing, new technology, and a decrease in government regulation or oversight. Those factors encourage economic expansion, leading to growth of earnings potential and thus of investment return, which would make assets genuinely more valuable.

A key study of the U.S. stock market points out that there are cultural as well as economic factors that can encourage or validate market inefficiency.Robert J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005). Examples include

• demographic factors of the population,
• attitudes reflected in the popular culture,
• the availability of information and analyses,
• the lowering of transaction costs.

These factors all lead to increased participation in the market and a tendency to “rationalize irrationality,” that is, to think that real economic or cultural changes, rather than mispricings, are changing the markets.

Sometimes mispricings occur when real economic and cultural changes are happening, however, so that what used to be seen a mispricing is actually seen as justifiable, fundamental value because the market itself has changed profoundly. An example is the dotcom bubble of 1990–2000, when stock prices of Internet start-up companies rose far higher than their value or earning capacity. Yet investors irrationally kept investing until the first wave of start-ups failed, bursting the market bubble.

Economic and cultural factors can prolong market inefficiency by reinforcing the behaviors that created it, in a kind of feedback loop. For example, financial news coverage in the media increased during the 1990s with the global saturation of cable and satellite television and radio, as well as the growth of the Internet.Robert J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005). More information availability can lead to more availability bias. Stereotyping can develop as a result of repeated “news,” resulting in representation bias, which encourages overconfidence or too little questioning or analysis of the situation. Misinterpreting market inefficiency as real changes can cause framing problems and other biases as well.

In this way, market inefficiencies can become self-fulfilling prophecies. Investing in an inefficient market causes asset values to rise, leading to gains and to more investments. The rise in asset values becomes self-reinforcing as it encourages anchoring, the expectation that asset values will continue to rise. Inefficiency becomes the norm. Those who do not invest in this market thus incur an opportunity cost. Participating in perpetuating market inefficiency, rather than correcting it, becomes the rational choice.

Reliance on media experts and informal communication or “word of mouth” reinforces this behavior to the point where it can become epidemic. It may not be mere coincidence, for example, that the stock market bubble of the 1920s happened as radio and telephone access became universal in the United States,See especially Robert J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005), 163. or that the stock boom of the 1990s coincided with the proliferation of mobile phones and e-mail, or that the real estate bubble of the 2000s coincided with our creation of the blogosphere.

Market efficiency requires that investors act independently so that the market reflects the consensus opinion of their independent judgments. Instead, the market may be reflecting the opinions of a few to whom others defer. Although the volume of market participation would seem to show lots of participation, few are actually participating. Most are simply following. The market then reflects the consensus of the few rather than the many; hence, the probability of mispricing rises.

It is difficult to know what is happening while you are in the middle of an inefficient market situation. It is easier to look back through market history and point out obvious panics or bubbles, but they were not so obvious to participants while they were happening. Hindsight allows a different perspective—it changes the frame—but as events happen, you can only work with the frame you have at the time.