Are Markets Efficient and / or Rational?

by: Katy Delay

There are investment advisors who claim that their clients should not worry about investing in the stock market because markets are inherently efficient, or rational. Are they efficient? That depends upon your definition of the word "efficient." Are they rational? That depends on your definition of "rational."

car
[Thanks to Hamiltoncountyfirefighters.com for the photo.]

I have pointed out previously that vocabulary is important, all the more so in any discussion of scientific subjects. Here are some definitions taken from Merriam-Webster:

Efficient:

1. being or involving the immediate agent in producing an effect
2. productive of desired effects; especially: productive without waste

Markets are efficient-No.1 in the sense that they produce an immediate effect. Are they efficient-No.2? Do they produce desired effects, or productive, unwasteful effects? That is the question.

If you are advising an investor to believe in markets because they are efficient, are you stating that they are efficient-No.1 or efficient-No.2? Isn't it possible that markets are efficient-No.1 but that they are not efficient-No.2, because they produce unproductive and wasteful side effects? And isn't it possible that one of the victims of those side effects is your client?

Rational:

1.b. relating to, based on, or agreeable to reason

Reason

1.c. a sufficient ground of explanation or of logical defense

Reasonable

1.a. being in accordance with reason
1.b. not extreme or excessive
1.c. moderate, fair
1.d. inexpensive

Markets are rational in the sense that there is certainly a logical sequence of events behind every movement, and those movements may have a logical defense, even if we are unable to discern their every step. But are they "reasonable," in any other sense than 1.a.? Hardly.

Markets are a machine. They function with all the givens and with nothing else, like an automobile. In a true free market (perhaps impossible to achieve), one might assume that markets would hand out justice where justice is due over the medium to long run, maintaining the course in spite of some waste. However, in markets such as we have today, with lots of government entities fighting over the driver's seat of our automobile, the result is a bunch of vehicles that can veer all over the road and hit a tree or each other in a most to-be-expected rational way but resulting in wasteful self-destruction.

Overseers of the markets cannot force them into productivity, efficiency, or fairness. I believe there is partial validity in the statement by certain economic theorists that all markets are efficient-No.1, and rational as explained above; but from there to assume, as certain investment advisors have done, that we should invest as though government had no destructive effect on markets, is a travesty.