Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
An Economist Finds A $10 Bill, And A Lesson On Efficient Markets…

January 1st, 2012 · 12 Comments
Behavioral Econ · Books · Markets

One of the first things I did in 2012 was find a $10 bill on the sidewalk in Harvard Square. I decided that this was a good sign for the new year, so I tweeted about it shortly after midnight. In retrospect, I should have known better, since I pretty quickly got the following responses:

Sigh. Yes yes, there’s an economist joke for just about everything. This one goes something like the following: An economist and a normal person are walking down the street together. The normal person says “Hey, look, there’s a $20 bill on the sidewalk!” The economist replies by saying “That’s impossible- if it were really a $20 bill, it would have been picked up by now.”

I guess the joke is that economists sometimes take the concept of efficient markets too far- in a financial sense, for example, the efficient markets hypothesis postulates that consistent excess returns in financial markets (i.e. free money) are impossible because market prices reflect all available information. The rationale behind the efficient markets hypothesis is that there are plenty of people and firms (hedge funds, etc.) just waiting to take advantage of any mispricings in the market, and capitalizing on these opportunities tends to adjust prices such that the opportunities go away.

Given this explanation, I hope that you are wondering something of the form “but if efficiency is maintained because of these people looking to exploit inefficiencies, doesn’t someone have to be profiting from whatever they are doing that drives away the inefficiency?” Ah, there might be some hope for those hedge fund managers yet, and, in fact, this principle can be illustrated by expanding the context of my story a little:

I found the $10 bill while walking with my roommate. My roommate had bent down to pick up a $1 bill off of the sidewalk (and was pretty excited about it), so my natural inclination was to scan the sidewalk to see if there was any other money lying around. It wasn’t so much that the money on sidewalk market was inefficient as it was the case that I got there first.

As such, Larry Swedroe offers a modified version of the joke:

A financial economist and passionate defender of the efficient markets hypothesis (EMH) was walking down the street with a friend. The friend stops and says, “Look, there’s a $20 bill on the ground.”

The economist turns and says, “Boy, this must be our lucky day! Better pick that up quick because the market is so efficient it won’t be there for very long. Finding a $20 bill lying around happens so infrequently that it would be foolish to spend our time searching for more of them. Certainly, after assigning a value to the time spent in the effort, an ‘investment’ in trying to find money lying on the street just waiting to be picked up would be a poor one. I am also certainly not aware of lots of people, if any, getting rich mining beaches with metal detectors.”

When he had finished they both look down and the $20 bill was gone!

So yeah, I’m not going to try to make a career out of trying to find money on the sidewalk, but I’m also not going to pass up an opportunity if it is, well, underfoot. Mainstream economists would probably offer the same advice to the marginal investor- it’s not so much that the “free money” isn’t there, but it is the case that if you want a piece of the action you have to figure out how to get in before everybody else. In other words, you can profit if you are better than other people at your job. But isn’t that true of just about everything?

Behavioral economists, on the other hand, offer evidence that markets are not as efficient as traditional economics would have us believe. Andrei Shleifer, for example, argues this point in his book Inefficient Markets: An Introduction to Behavioral Finance:

The efficient markets hypothesis has been the central proposition in finance for nearly thirty years. It states that securities prices in financial markets must equal fundamental values, either because all investors are rational or because arbitrage eliminates pricing anomalies. This book describes an alternative approach to the study of financial markets: behavioral finance. This approach starts with an observation that the assumptions of investor rationality and perfect arbitrage are overwhelmingly contradicted by both psychological and institutional evidence. In actual financial markets, less than fully rational investors trade against arbitrageurs whose resources are limited by risk aversion, short horizons, and agency problems. The book presents models of such markets. These models explain the available financial data more accurately than the efficient markets hypothesis, and generate new predictions about security prices.

Given this evidence, I suppose my conclusion that would be that, if you want to find free money, you have to either be better at your job or not exhibit the same biases and restrictions as the rest of the market. I’m guessing that that latter part is harder than it sounds, since otherwise wouldn’t Professor Shleifer have used his knowledge to make a big pile of free money rather than just tell the rest of the world what they were doing “wrong?”

You will be happy to know that the $10 bought me my first iced latte of the year…and, the way the year looks to be shaping up, there will be many more of these in the near future. (Lattes, not free $10 bills, sadly.)

Update: Matt Yglesias at Slate likes my story but doesn’t like this particular use of the term “efficient.” I tend to agree- most of the time, when economists use the term “efficient,” it actually refers to some concept of maximizing societal well being. In the case of financial markets, on the other hand, an “efficient” outcome can be a pretty crappy one for all involved.

Tags: Behavioral Econ · Books · Markets

12 responses so far ↓

  • 1 Russ Nelson // Jan 1, 2012 at 8:32 pm

    If you want to see the EMH disproven, look at http://quibid.com . Bids seem to always be a penny, and cost the bidder $0.60. Items sell for 90 % of list price, but 500% profit for the seller.

  • 2 Randy Boring // Jan 1, 2012 at 10:04 pm

    “I am also certainly not aware of lots of people, if any, getting rich mining beaches with metal detectors.”

    The sidewalks of NYC’s diamond district have enough deposited recoverably to make money for someone: http://amog.com/offbeat/101365-streets-lined-gold/

    Of course, “not aware” is the key here, and key to why markets are not perfectly efficient. Information is not perfect or complete.

    But free markets are the *best* method we have of distributing resources, since the important knowledge is distributed amongst us all, and working together we are more efficient than the best central planners.

  • 3 Rho // Jan 2, 2012 at 1:34 am

    Don’t underestimate lucky. Someone will find the dollar. Think better, different, & get lucky once in a while. Taleb would call that increasing the probability of positive black swans.

  • 4 Eat The Babies! // Jan 3, 2012 at 11:47 am

    Not only is that a classic economist joke, I would say that it is THE classic economist joke. It’s the ur-economist joke.

    Speaking of which, Econtalk featured a great conversation on this subject recently, too. I listened to it this weekend: http://www.econtalk.org/archives/2011/12/munger_on_profi.html

  • 5 Rho // Jan 3, 2012 at 1:06 pm

    An economist, a physicist, and an engineer are stranded on an island with only a crate of canned food . The economist’s solution? Assume a can opener. That is a classic.

  • 6 jonathan // Jan 3, 2012 at 4:58 pm

    Successful investing is anticipating the anticipations of others.

    So said Keynes

  • 7 Uncle Jeffy // Jan 4, 2012 at 12:53 am

    Economist gets on a bus from the Chicago Loop to the Hyde Park campus of Univ. of Chicago. Other than the driver, he’s the only occupant of the bus. A few minutes into the ride, it starts to rain heavily and the passenger is doused with water from a leak in the roof of the bus, but he just sits there. Finally, the driver looks back and says, “Hey, buddy, why don’t you switch seats?”

    The economist says, “With whom?”

  • 8 Eat The Babies! // Jan 4, 2012 at 3:06 pm

    Please, please, please keep this thread going. More, please!

  • 9 Christopher Scott // Jan 12, 2012 at 8:38 pm

    This reminds me of a lesson I learned in my Derivatives valuation class. Sometimes, in order to build a model, you need to make assumptions. While these assumptions may not be 100% true (EMH), it still helps you build a model that does a good job describing how the world works. However, you need to always keep two things in mind

    1) Your model is always wrong
    2) The market is always wrong

  • 10 A modern version of an old economists joke // Jun 3, 2014 at 11:01 pm

    [...] You’ve all heard the joke about the Chicago economist who doesn’t pick up the $20 note on the pavement, as someone would have picked it up already. All very good – it is discussed over at “Economist’s do it with models”. [...]

  • 11 Northfield | Transportationist // Jun 9, 2014 at 8:13 am

    [...] of $10 bills lying on the street. (In the rational expectations world of economics, there are no $10 bills lying on the street, because someone would have picked them up already). I think we know better, that there are lots of [...]

  • 12 vietnam tourist visa uk // Oct 6, 2014 at 1:06 am

    Hey! This post could not be written any better!
    Reading through this post reminds me of my old room mate!
    He always kept talking about this. I will forward this article to him.
    Pretty sure he will have a good read. Thank you for sharing!

Leave a Comment