Apparent ailocative efficiency of the us economy was

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apparent ailocative efficiency of the U.S. economy was hard to reconcile with pervasive irrational behavior. Perhaps unconsciously, these arguments underlie the intuitive a priori idea that many finan cial economists have that markets are rational. A more consciously held position, given full voice by 18 ©2001 Association for Investment Management and Research® Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Rational Markets Hayek (1945), is that the prices produced in corn petitive and reasonably liquid markets aggregate the information potentially known by millions of diverse investors drawn from all corners of the earth: The peculiar character of the problem of ratio nal economic order is determined precisely by the fact that the knowledge of the circum stances of which we must make use never exists in concentrate or integrated form, but solely as dispersed bits of incomplete and frequently contradictory knowledge which all the sepa rate individuals possess. The economic prob lem of society is thus a problem of the utilization of knowledge not given to anyone in its totality. The most significant fact about the [price] system is the economy of knowledge with which it operates, or how little the indi vidual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essen tial information is passed on and passed on only to those concemed. (p. 525) Each investor, using the market to serve his or her own self-interest, unwittingly makes prices reflect that investor’s information and analysis. It is as if the market were a huge, relatively low-cost continuous polling mechanism that records the updated votes of millions of investors in continu ously changing current prices. In light of this mech anism, for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be embedded in prices. Indeed, stocks are highly responsive to news that clearly relates to them. Even if an investor is fortunate enough to be possessed of nonpublic but not inside information, it may do her more harm than good if she is tempted to take a position based on the information, for the price may already reflect other nonpublic information known to other investors that may nullify the effect of her information. So, one of the lessons of modem financial economics is that an investor must take care to consider the vast amount of information already impounded in a price before making abetbased on information. The securities market is not the only example for which the aggregation of information across individuals leads to the truth. At 3:15 p.m. on May 27,1968, the submarine USS Scorpion was officially declared missing with all 99 men aboard. She was somewhere within a 20-mile-wide circle in the Atlantic Ocean, far below implosion depth. Five months later, after extensive search efforts, her location within that circle was still undetermined.

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