Participants in financial markets are usually categorised as informed or uninformed. Here we expand this classification by including another group which we refer to as the foolish participants. Foolish traders actively transact at inefficient prices to their own detriment.

Informed agents spend resources to obtain all the price sensitive information required to calculate the fair prices of securities. Uninformed agents, such as passive or index-tracking investors, transact without knowing the fair price of a security.  They trust that informed agents will ensure that the market remains efficient, but consequently forfeit some returns to the informed traders, refer to my earlier post. Uninformed agents, though, would only transact when their circumstances change, as discussed earlier.

As the market is a zero-sum game, the underperformance by uninformed agents equals the outperformance by informed participants, after costs. The magnitude of underperformance will be a function of the value of an uninformed agent’s transactions. The more active they are, the more likely it is that they trade in securities whose prices do not yet reflect all new price sensitive information. The more significant the effect of new price sensitive information on a security’s valuation, the larger will be the underperformance of the uninformed agent who is transacting in that security.

We introduce here a third group, called the foolish participants, who would transact without having knowledge of the fair prices of securities. However, unlike rational uninformed participants, they would trade actively in a security with the aim to outperform. In the literature, such participants are also referred to as irrational or noise traders.

Foolish agents would, therefore, trade more frequently than rational uninformed traders, and therefore, more often at inefficient prices. Consequently, they would perform worse than the uninformed traders. The foolish traders decrease the market’s efficiency and thanks to them the magnitude of outperformance by informed agents improve. The larger the foolish group, the more money the informed investors can make to the detriment of the foolish agents.

So, why would there be foolish market participants? Would they not realise in time that they will be better off by following a passive investment strategy?  Should they not over time disappear as suggested by Milton Friedman1. In a following post we will examine this group of foolish traders in more detail by classifying them into deluded, gambling and irrational market participants.   We will consider reasons and possible evidence for their existence.

The ability of foolish traders to consistently underperform the market can be considered a “skill” that can be exploited, using the idea of portable alpha. To obtain the market return, invest in the market-capitalisation-weighted index. For an additional return, which is called the “alpha”, sell the portfolio of a foolish investor short and use the proceeds to buy all market securities, weighted proportionally to their market capitalisation. Relative to the market-cap-weighted benchmark the combined portfolio is now underweight securities which the foolish investor considered to be winners and overweight securities he considered to be losers and hence will outperform. 

So in conclusion, if a group of foolish participants exists, it implies that the market is inefficient because it is possible to outperform consistently by using the above strategy.

1Friedman, Milton, 1953, The case for flexible exchange rates, in Essays in Positive Economics (University of Chicago Press, Chicago).