Markets 12. Market Efficiency The McGraw−Hill Companies, 2001

342 PART III Equilibrium in Capital Markets

Competition as the Source of Efficiency

Why should we expect stock prices to reflect "all available information"? After all, if you are willing to spend time and money on gathering information, it might seem reasonable that you could turn up something that has been overlooked by the rest of the investment community. When information is costly to uncover and analyze, one would expect invest- ment analysis calling for such expenditures to result in an increased expected return.

This point has been stressed by Grossman and Stiglitz. 4 They argued that investors will have an incentive to spend time and resources to analyze and uncover new information only if such activity is likely to generate higher investment returns. Thus, in market equi- librium, efficient information-gathering activity should be fruitful. Moreover, it would not be surprising to find that the degree of efficiency differs across various markets. For ex- ample, emerging markets that are less intensively analyzed than U.S. markets and in which accounting disclosure requirements are much less rigorous may be less efficient than U.S. markets. Small stocks which receive relatively little coverage by Wall Street analysts may be less efficiently priced than large ones. Therefore, while we would not go so far as to say that you absolutely cannot come up with new information, it still makes sense to consider and respect your competition.

Consider an investment management fund currently managing a $5 billion portfolio. Suppose that the fund manager can devise a research program that could increase the port- folio rate of return by one-tenth of 1% per year, a seemingly modest amount. This program would increase the dollar return to the portfolio by $5 billion .001, or $5 million. There- fore, the fund would be willing to spend up to $5 million per year on research to increase stock returns by a mere tenth of 1% per year. With such large rewards for such small in- creases in investment performance, it should not be surprising that professional portfolio managers are willing to spend large sums on industry analysts, computer support, and re- search effort, and therefore that price changes are, generally speaking, difficult to predict.

With so many well-backed analysts willing to spend considerable resources on research, easy pickings in the market are rare. Moreover, the incremental rates of return on research activity are likely to be so small that only managers of the largest portfolios will find them worth pursuing.

Although it may not literally be true that "all" relevant information will be uncovered, it is virtually certain that there are many investigators hot on the trail of most leads that seem likely to improve investment performance. Competition among these many well- backed, highly paid, aggressive analysts ensures that, as a general rule, stock prices ought to reflect available information regarding their proper levels.