Saturday, 4 October 2014

Markets aren't usually efficient, nor are they usually fair

Fortune magazine recently carried an interview with Robert Greifeld, chief of NASDAQ, which now operates 26 trading platforms around the world. Pity he did not address high frequency trading, which was flagged in the introduction.  But he did suggest that the markets add value and are a benefit for all.  Well he would, wouldn't he?  I would just like to make a point on behalf of the small retail investors, such as myself, before turning to the market efficiency question.

Mr Griefeld says "Contrary to what you might think, retail participation in the market has been on the increase since 2012 and that increase has continued into 2014", in response to the suggestion that retail investors are a little bit scared.  But this does not address why they are increasing their exposure to equity markets.  Is it not more likely that they have simply been pushed into equity investment  by the pathetic returns now available for cash?  They know the risks are high but they don't have much choice.

As to efficiency and value of markets, it cannot be denied that markets are needed to bring enterprises and investors together.  It is also true that greater liquidity and volumes will make the process more efficient and bring unit costs down.  However that is only a relative measure.  Why is it that immense wealth is generated for market makers, traders, hedge fund managers (and sometimes their super rich clients) if the process is so efficient?  It seems obvious to me that this happens in two ways:
 Markets are not efficient and information flow is not perfect, as free market economics requires.  At least from the retail investor perspective, not having the huge investment in technology at my fingertips, markets have always already responded to news before I ever find out about it, so the retail investor misses out while the professionals clean up (all the more reason to invest on value for the long term).
Traders, who are not to interested in holding the underlying investments for their own sake add volume but no value beyond the "liquidity".  But there is no correlation between the profits earned on this business and the value added.  With the market largely being a zero sum game, at least in the short run, then that means these profits are at the expense of someone else, including the private investor and pension holder.

Don't get me wrong, I don't think our free enterprise market-based system is especially bad. Paraphrasing Churchill on democracy, capitalism and free markets are the worst form of social organisation, except for all those other forms that have been tried from time to time.  But let's not pretend that unfettered markets are efficient.  Even libertarians accept that.  But neither are they necessarily fair, or deliver the kind of society most people want to live in.    That is why  governments need to regulate, monitor and to correct.

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