Limitations to Achieving Fully Efficient Markets

There are three significant limitations to achieving fully efficient markets: the cost of information, the cost of trading, and limits of arbitrage.

Cost of Information

A fully efficient market requires that all new information be processed instantaneously and fully reflected in the share price. However, if all information is fully priced instantaneously there is no incentive for any market participant to process the information. The time and effort expended would not earn a return. In order for markets to become efficient, there must be just enough inefficiency to make the efforts worthwhile.

Cost of Trading

Trading costs include brokerage fees, taxes, and research time. High trading costs reduce the incentive to trade, and small inefficiencies may not be priced away.

Limitations to Arbitrage

Ideally, if two securities are mispriced relative to their risk one can be sold short and the other purchased. The sale of one and purchase of the other will drive both toward their efficient price. In practice, there are four problems associated with this.

  1. It is uncertain when, if ever, prices will return to equilibrium. The mispricing could become even more pronounced in the meantime, potentially forcing the arbitrageur to close the position.
  2. Two assets rarely have identical risks. If there are no close substitutes for a given security, no arbitrage may be possible.
  3. Arbitrageurs have limited access to capital. Only the most egregious mispricings can be exploited.
  4. Arbitrageurs may face restrictions on trading by the owners of the capital they employ.
For more information, see all articles on: Uncategorized

See also:
  • Efficient Market Hypothesis: Semi-Strong Form
  • Are Markets Semistrong Form Efficient?
  • Efficient Markets
  • Efficient Market Hypothesis: Weak Form
  • Creating an Index Portfolio Using Total Return Swaps
  • Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points

    The Intelligent Investor: The Classic Text on Value Investing

    Financial Statement Analysis: A Practitioner's Guide, 3rd Edition

    Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

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