The extent to which a skilful manager can outperform varies with time. It depends, primarily on the dispersion of security returns in a measurement period. If we want to judge investment skill, we need to be aware of the effect of market dispersion.
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Professional investors are usually either skilled (informed) or incompetent (deluded), but can one actually demonstrate such skill or incompetence empirically?
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In previous posts we considered informed and uninformed market participants. We then introduced another type of participant which we called the foolish investor. In an attempt to outperform the market foolish market participants actively trade to their own detriment at inefficient prices. Here we refine our definition of foolish market participants by dividing them into three groups: the gamblers, the deluded traders and the irrational traders. Each group is foolish in a different way.
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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.
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Consider a securities market where price-sensitive information is available only to participants who pay a fixed cost in money or effort. So only paid-up agents know the fair prices of securities. However, not all agents would be willing to pay for information. Some would argue that because there are enough informed market participants, ensuring that securities are correctly priced, why then incur the “unnecessary” cost of gathering information?
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