Inefficient Markets by Andrei Shleifer

Inefficient Marketsby Anonymous

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August 21, 2000: In this book, Professor Schleifer has collected some of his older papers, and given this collection a fashionable title, by making references both to market inefficiency and behavioral finance. The truth is that these references don't make too much sense, since he neither gives an introduction to behavioral finance (the study of how people make decisions under financial uncertainty), nor does he provide the reader with convincing arguments on why markets are inefficient. In chapter 2, he introduces the noise trader hypothesis, based on an article he wrote in the Journal of Finace (JOF) in 1990. The problem with the noise trader hypothesis is that it is hardly a behavioral assumption; specifically it does not explain why people make a biased decision when faced with financial uncertainty. Moreover, the noise trader hypothesis is untestable. In the end, it is just an easy way of getting around some of the existing paradoxes in finance, by assuming that people are stupid - say noisy, in Schleifer's vocabulary. In chapter 4, he is concerned with the 'limits of arbitrage' (the original title of this paper, published in the JOF in 1997). This paper is definitely worth reading to understand the problems with hedge funds and other arbitrageurs. However, linking the limits of arbitrageurs to 'inefficiency of the market' is erroneous. The very fact that arbitrageurs can not take advantage of what they think are mispriced assets, due to collateral constraints (Schleifer's hypothesis), shows that the market is efficient, since no free money is floating around. The other chapters can be criticized in similar ways. E.g. chapter 3 on closed end funds has been criticized by his peers (Merton Miller, a.o.) in the JOF of 1993. Nevertheless, this book is worth reading, since most of the articles Schleifer has written have been influential, placed in their proper context. However, anybody who thinks that he's getting a good introduction to either inefficient market theory or behavioral finance, will feel deceived at the end of this book.