Rare disasters and the efficient markets hypothesis

One common strand in financial economics research is that financial markets are not perfectly efficient, i.e. they do not immediately and consistently incorporate all facts about the world in prices. I have several feeds set up for new papers in the area and at least five new papers come out each week finding that while markets are far more efficient than random, there are a number of departures from perfect efficiency.

I had always wondered why this was true: surely if there really are all these easily-exploitable bets then there would be at least some market participants who would exploit the hell out of them. Markets do not come to rest at the median view of everyone, but the position where no one wants to trade—so it doesn't matter if most people are 'behavioural'.

If the inefficiencies—i.e. prices that differ from fundamental values—cannot be bet on then there's a question of why: if it's down to regulation then that's hardly surprising and doesn't really tell us anything about markets; if it's down to the (non-regulatory) cost of trading then it's not an inefficiency. It's more socially efficient all things considered to not trade on those inefficiencies—i.e. the social benefits of getting to the true price are outweighed by the social costs needed to get there.

Well a new paper seems to give a strong undergirding to my thoughts here. Entitled "Disaster risk and its implications for asset pricing" (pdf) and authored by Jerry Tsai and Jessica Wachter (hat tip to Robin Hanson), it says that most of these inconsistencies are parsimoniously accounted for by the risks of catastrophic disasters like the Great Depression.

These make certain sorts of assets (like stocks) less attractive by dint of the fact there is a very small chance that they might tank a huge amount. Otherwise there seems to be a big puzzle why stocks return so much more than bonds.

After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

This probably leaves a few market puzzles unexplained—perhaps many—but I expect these may eventually yield simple, plausible and efficiency-preserving explanations. As Eugene Fama points out in a brilliantly clear introduction to and history of the EMH it is very hard to test market efficiency since you must always make assumptions about risk at the same time.