“Went out to dinner the other night, check came at the end of the meal as it always does. Never liked the check at the end of the meal system. Because money’s a very different thing before and after you eat. Before you eat money has no value. And you don’t care about money when you’re hungry, you sit down in a restaurant, you’re like the ruler of an empire. “More drinks, appetizers, quickly, quickly. It will be the greatest meal of our lives.” Then after the meal, you know, you’ve got the pants open, you’ve got the napkins destroyed, cigarette butt in the mashed potatoes. Then the check comes at that moment. People are always upset, you know, they’re mystified by the check. “What is this? How could this be?” They start passing it around the table, “Does this look right to you? We’re not hungry now, why are we buying all this food?” — Jerry Seinfeld 
Markets manufacture information; and prices are the most important information they manufacture. But is that information a reliable indicator of the worth of an asset if human cognition affects the setting of prices or the way we judge prices? Seinfeld says, “money’s a very different thing before and after you eat.” Something about human cognition affects the way we look at transactions. Possible market inefficiencies and cognitive biases raise tantalizing possibilities for financial innovators. This was our focus in week 4 of the course.
A market is efficient if prices fully reflect available information. The efficiency of prices for impounding “available information” has been tested against (a) historical price trends, (b) current public information, and (c) all public and private information—these standards are called the weak, semi-strong, and strong forms of efficiency. Early research found that U.S. equity markets are efficient with respect to (a) and (b) but not (c)—you can make a killing by trading on inside information (and possibly go to jail for doing so).
Market inefficiency can drive financial innovation. More recent research found persistent inefficiencies, both within and across markets. These findings are well summarized by Andrei Shleifer in his book, Inefficient Markets: An Introduction to Behavioral Finance. Inefficiencies arise because of what economists call “limits to arbitrage.” Arbitrage involves the matched buying and selling of assets in order to exploit different prices for essentially the same asset. Here are some examples:
Ø In a perfect world, a ton of grain would command the same price everywhere; economists call this the “Law of One Price.” Suppose that communication problems prevent traders in a distant market from being fully informed about grain production and demand across the world. The difference could motivate arbitrageurs to buy a ton of grain in the low-priced market, ship it to the high-priced market, sell it there and pocket the difference between the two prices.
Ø In a perfect world, a McDonald’s “Big Mac” hamburger would command the same price everywhere, since it is made to uniform specifications. Yet, as the Economist magazine reports each year in its Big Mac Index, prices vary around the world. In theory, you could buy lots of Big Macs in low-price countries and transport them for sale in high-price countries. And in theory, doing so should drive up the price in the low-price country and drive down the price in the high-price country. (I’ll get to the limits to this in a moment.)
Ø In a perfect world, a dollar of earnings produced at one hotel chain (say, Hilton) should be worth as much as a dollar of earnings at another very similar hotel chain (say, Marriott). Where the earnings multiples deviate, you could buy shares in the low-priced chain and sell short shares in the high-priced chain, which would tend to equilibrate the prices of the two hotel chains.
And so on…
But I kept qualifying my examples with “In a perfect world” which is economistspeak for a world of competitive, well-informed, and frictionless trading. Prices can differ across markets because of:
· Frictions: An “arb” (slang for arbitrageur) needs to see a return on a trade commensurate with the risk the arb foresees. Structural factors such as regulations, slow information technology, transportation problems, margin requirements, taxes, and possible delays in closing the trade increase the costs or uncertainty of a trade. Government intervention in currency markets would be a prime explanation for the fact that McDonald’s Big Macs sell for different prices around the world. In most markets, there are usually many low-risk, low-return investment opportunities—but these won’t get the arb’s attention because of the cost of frictions or the arb’s high opportunity cost on her time and attention. Across markets, there will be a host of smallish deviations from the Law of One Price.
· Limits to arbitrage: If you perceive an over-pricing of oil paintings by the old Dutch Masters, you decide to sell all your old Dutch Masters paintings and buy…what? Modernists? Arbitrage can be limited where it is difficult to find a comparable asset with which to complete the trade.
· Cognitive biases. Humans are fallible. They lazily project recent experience into the future. They are more averse to losses than happy about gains. They overreact to news (out of overconfidence or fear). They can move in herds of sentiment. They introduce “noise” into market prices. Noise traders are the bane of professional arbitrageurs and behave socially by trading on rumors and imitating the behavior of others. In contrast to the theory of market efficiency and rationality, in which the trading of erratic individuals cancels out, noise traders move in herd-like fashion and don’t cancel each other out.
Financial innovators seek to exploit market inefficiencies or to protect market participants from the adverse effects of their own cognitive biases. Consider some examples:
ü High frequency trading—as described in Michael Lewis’s book, Flash Boys: A Wall Street Revolt—exploits delays trading. By observing demand, supply, and other trading signals, and by front-running before other trades get to the market, the innovator exploits a consistent advantage versus other traders. The inefficiency here is that not everyone is equally well-informed at every moment in time. In the case of high frequency trading, the difference in time might be a matter of a few milliseconds. Lewis describes Brad Katsuyama, an innovator who developed the IEX Market and sought to prevent such front-running by eliminating the inefficiency.
ü Life-cycle investing. Individual investors tend to get stuck in a rut: they manage their own wealth in ways that past experience proved to offer some success. Typically, one invests in stocks when young and then enjoys a sizeable build-up of wealth over the decades. The problem is that one’s tolerance for market risk declines by one’s retirement years, causing investors to hang on too long to past strategies. In response to this problem, financial innovators developed life-cycle investment plans that would automatically shift the investor’s portfolio from risky stocks to less risky fixed income securities as the investor approaches retirement.
ü Democratization of financial news. It used to be that to become well-informed about asset prices meant that you needed to pay expensive commissions to brokers and/or expensive subscriptions to financial publishers. Now, the world is awash in low-priced financial information. Expert discovery and interpretation of the financial news helps to separate the important signal from market “noise.” Ratings agencies and the financial press were founded in the 19th Century to help discover and interpret the meaning of news—today, such interpretations are available virtually free on the Internet. More often than not it can be fairly said that if you don’t know what’s going on, you aren’t paying attention.
ü Digital awareness. Today, various apps and online platforms help to awaken the attention of investors to price movements through warnings and alerts. Social media, such as Twitter, enable one to follow trending sentiments
What do inefficiency and cognitive biases mean for financial innovators?
1. Financial innovations may help to reduce market inefficiencies and correct cognitive biases. Underlying many innovations is an arbitrage of some kind. Arbitrage helps to drive prices into alignment, or parity, or “fairness.” Therefore, a key question is, what are the limits to arbitrage in your market?
2. It is hard, if not impossible to “beat the market” with any consistency if the market is efficient—this is the gist of Burton Malkiel’s famous book, A Random Walk Down Wall Street. He argues that for the typical individual investor, a passive investing strategy of buying-and-holding a well-diversified portfolio of stocks (such as in an index fund) will dominate a strategy of active trading. Large institutional investors help to produce efficiency. They trade in high volume and have very sophisticated information infrastructure. Dick Mayo, a visitor in our course, has described how Jeremy Grantham (a financial innovator) invented the concept of the index fund to enable investors to buy and hold a diversified portfolio at low transaction cost. The most important implication for financial innovators is that “noise trading” won’t pay. Don’t be a noise trader.
3. How efficient is the market you aim to serve? We discussed the differences in efficiency among the markets for U.S. Treasury bonds, shares in General Electric, gold, and old masters paintings. The market in U.S. Treasury bonds is highly efficient: it is the biggest and most liquid financial market in the world. News is impounded almost instantaneously and seems to reflect expectations about inflation, interest rates, economic growth, and currency exchange rates fairly well. The market for shares in GE is also pretty efficient. Gold is subject to irrational swings in value and bouts of mania or depression. The market in old masters paintings is characterized by low liquidity, the mania of collectors, and the occasional fraud. Housing markets are hugely influenced by local factors that one would discern only by on-the-ground research—these factors could drive important pricing inefficiencies. Across the wide variety of assets, it may be safest to assume that every market is inefficient to some extent. The key questions are how inefficient, and why?
4. What do you know that the market does not know? And vice versa. You may think that you’ve discovered that Hilton is priced too high relative to Marriott and other hoteliers. But before you trade on that belief, dig beneath it with research. It may be too good to be true. Good questions to ask: is your belief based in facts or is it just an opinion? Could your belief be tainted by your own cognitive biases?
5. In inefficient markets, be alert to predators. The predators may not think of themselves as predators: the HFT front-runners in Flash Boys liked to believe that they were bringing added liquidity and efficiency to the stock market. Payday lenders make a similar argument. But see point #1: inefficiencies and cognitive biases present profit-making opportunities; righteousness might cloak avarice. To be safe, check who is driving what inefficiency at whose expense. Warren Buffett said that “any player unaware of the fool in the market probably is the fool in the market.”  As the course goes forward, we should discuss more fully what we mean by “predation.”
At the end of Jerry Seinfeld’s skit, he said,
“I’m not an investor. People always tell me, you should have your money working for you. I’ve decided I’ll do the work. I’m gonna let the money relax. You know what I mean, ‘cause you send your money out there working for you—a lot of times it gets fired. You go back there, “What happened, I had my money, it was here, it was working for me.” “Yeah, I remember your money, showing up late, taking time off. We had to let him go.” 
Seinfeld bids for our sympathy because he is uninformed—putting your money to work is a very good thing to do. Being uninformed (“I’m not an investor”) and nursing a cognitive bias (“a lot of times it gets fired”) are the root causes of market inefficiency. Financial innovation can help people with these problems.