It is not possible to refute the existence of skilful investors, as explained in my previous post. So, can we test whether there are investment managers with skill by analysing their investment returns? Investment performance can only be judged on a relative basis. The two candidates to evaluate performance against are either a peer group or a defined benchmark. We consider the merits of both.
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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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Irrational traders know the fundamental value of a security, but rather than basing their trading decisions on this, they base it on their expectations of how other market participants will behave. Here we discuss experimental evidence demonstrating this irrational behaviour. We consider bubbles and IPOs as real life examples.
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Deluded investors are foolish market participants who are uninformed but transact in financial markets with the delusion that they are informed. They would trade actively in an attempt to outperform when a security is mispriced according to their analysis. Deluded participants are, however, wrong in believing that they know the fair value of the security.
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We have classified market participants into five types. In this post we describe the irrational investors or traders in more detail. As explained before, the irrational traders are the market participants who are informed, but still transact although they understand that they are buying securities above fair value or are selling securities below fair value. Even so, they believe that their strategy will lead to outperformance.
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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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Latency arbitrageurs outperform efficient markets. To explain this, we describe the flow of new price sensitive information into financial markets using three steps.
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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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Even if we assume that all information is available to everyone at the same time at no cost it is still possible to outperform an “efficient market”, thus exposing a paradox in the “efficient market” definition.
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