A view of the Bombay Stock Exchange in Mumbai.
| Photo Credit: Reuters

For representative purposes.
| Photo Credit: Getty Images

Contrary to popular wisdom, financial markets today are not as efficient as they used to be just a few decades ago, argues billionaire investor and co-founder of AQR Capital Management Clifford S. Asness in his forthcoming paper “The Less-Efficient Market Hypothesis” in the Journal of Portfolio Management.

Market efficiency refers to how well the market price of assets, such as common stocks for example, reflect the information that is available to investors about these assets. Financial experts believe that markets, while not perfectly efficient, are highly efficient since there are millions of investors in the market trying on a daily basis to gather as much information as possible about assets and take advantage of any inefficiencies in the pricing of these assets. So, for example, if a company’s stock is trading at a really cheap price when compared to its likely future cash flow, this would attract investors who are looking for a good bargain, thus ensuring that the price of the stock is quickly bid up in the process and the market becomes efficient.

In the modern world, where information about assets is more easily available than ever before and can spread quickly among investors, we might expect assets to be priced efficiently. In fact, some have argued that with the advent of technology, assets have become priced so efficiently that traditional investing approaches such as value investing, which relies on purchasing assets that are selling below their fair value or priced inefficiently, have become irrelevant in today’s market. But Asness argues that the “value spread,” or the gap between the valuation of expensive large-cap stocks in the market as against the cheap large-cap stocks regardless of what measure is used to value these stocks, has actually risen significantly compared to just a few decades ago. In other words, investors are paying too much for stocks that they fancy while deserting stocks that they don’t like so much, causing the extreme overvaluation of some stocks and the undervaluation of other stocks.

The impact of social media

When certain stocks are overvalued while others are undervalued, one might expect investors to avoid overvalued stocks and purchase undervalued stocks, thus helping correct pricing inefficiencies. But Asness notes that this is not happening so much anymore in markets, and that discrepancies in the pricing of expensive and cheap stocks have lasted longer than in the earlier decades. He attributes various reasons for this, but considers the rise of social media and the ease with which stocks can be bought or sold these days as the most important reason. The rise of social media has meant that investors are more likely to gang up and hold similar opinions about stocks that they bet on, he argues, causing the overvaluation of these stocks and the undervaluation of others. On the other hand, there are very few investors who are willing to make a contrarian bet on undervalued stocks, thus depressing the prices of these assets. Asness believes the rise of passive index investing might be aggravating the problem as it leads to investors piling big into a few stocks which possess momentum.

Why does market efficiency matter? It matters because the proper pricing of assets is crucial to how capital is allocated towards competing ends in society, which in turn determines how efficiently resources are used. For example, when assets are priced efficiently companies with bright future prospects get more capital from investors than other companies. When assets are not priced properly this can lead to capital being misallocated to companies that don’t really deserve it, leading to the inefficient use of scarce resources.