SOME MARKET THEORY

We've all heard or read about the miraculous efficiency of the free market, usually called efficient market theory, especially as it is manifested in the securities markets. Frank Partnoy in INFECTIOUS GREED noted that the relatively new field of behavioral finance has cast serious doubt on this model of economic behavior. As Partnoy puts it (page 273):

...many banking and securities experts ... had been arguing for a decade that unregulated markets didn't allocate risk in an efficient or fair manner. Instead, ...risks were like hot potatoes being passed to the people least able to hold on to them.

The off-loading of the sub-prime risk onto relatively tiny insurers seems to be one example of passing the "hot potato." There is a broader point to behavioral theory: people aren't rational and neither is the securities market. One great example is Palm, the maker of the Palm Pilot. 3Com, the owner of Palm, sold 5% of the shares, retaining 95%. The market valuation of Palm ended up being greater than 3Com, so here we have a case of a part being worth more than the whole. (Partnoy, pp. 274-75)

Behavioral economist Robert J. Schiller described this well in "From Efficient Market Theory to Behavioral Finance":

One such efficient markets model makes the discount rate correspond to interest rates;see the line labeled “present value, discounted by interest rates” in Figure 1.6 Unfortunately for efficient markets theory, allowing time-varying interest rates in the present value formula does little to support the efficient markets model. The actual price is still more volatile than the present value, especially for the latest half century.

...we have to distance ourselves from the presumption that financial markets always work well, and that price changes always reflect genuine information.