Efficient markets

Robert Shiller in the NYTimes on information cascades:

ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.


Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.


The fundamental problem is that the information obtained by any individual — even one as well-placed as the chairman of the Federal Reserve — is bound to be incomplete. If people could somehow hold a national town meeting and share their independent information, they would have the opportunity to see the full weight of the evidence. Any individual errors would be averaged out, and the participants would collectively reach the correct decision.

Of course, such a national town meeting is impossible. Each person makes decisions individually, sequentially, and reveals his decisions through actions — in this case, by entering the housing market and bidding up home prices.

Suppose houses are really of low investment value, but the first person to make a decision reaches the wrong conclusion (which happens, as we have assumed, 40 percent of the time). The first person, A, pays a high price for a home, thus signaling to others that houses are a good investment.

The second person, B, has no problem if his own data seem to confirm the information provided by A’s willingness to pay a high price. But B faces a quandary if his own information seems to contradict A’s judgment. In that case, B would conclude that he has no worthwhile information, and so he must make an arbitrary decision — say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.

As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.
First, this article reminds me of all those guys that tried to prove that there wasn't a housing crisis in '07 by pointing at market reactions. At least Ben Stein used external data points to hypothesize that nothing was happening.

Less snidely, I think this crystallizes/explains an argument that I've had against the efficiency of markets for a long time. Think about markets as a Wikipedia for pricing information. Looking past a lot of the obvious parallels (e.g. crowd sourcing, larger players having a marked impact on the outcome, etc.), there is one key difference. In writing a Wikipedia article, you could never cite Wikipedia as the source. As hypothesized above, this doesn't seem to be the case with the market.



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