Market Efficiency and Trader Rationality

I survey the findings from several research papers that use data from the Iowa Electronic Markets to analyze both market level and individual phenomenon in financial markets. The research shows that there is no simple correspondence between individually rational traders and market level efficiency. Instead, the markets appear quite efficient at an aggregate level while the traders in the markets frequently appear individually irrational. I will discuss results from three papers: (1) Surprisingly few factors explain the variances in relative price efficiencies and that these factors are also largely consistent with market microstructure models. This documents the high degree of efficiency at the market level. (2) Traders in the IEM consistently voilate the assumption of efficient pricing by creating and failing to exploit arbitrage opportunities. However, in spite of surprisingly frequent apparent violations of rationality, prices in the IEM appear very efficient in that toward the end of each market, they reflect closely ultimate liquidation values. These results leave us with several issues to study. First, how can markets with frequent and obvious violations in individual rationality be price efficient? Second, what explains these deviations from rationality? Third, what explains the differences between results in otherwise similar laboratory and field markets? (3) While individual traders are subject to a host of potential psychological biases, those marginal traders who drive the market prices are largely free of these biases. Thus, the simultaneous existence of efficient markets with irrational traders can be reconciled if one recognizes the differences between average or typical traders and marginal traders who set prices.

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Table of Contents Market Efficiency and Trader Rationality The big question: How do markets ìwork?î The big question: How do markets ìwork?î The big question: How do markets ìwork?î Some observations Our laboratories and research questions Vocabulary: Rationality, biases and non-optimizing behaviors Vocabulary: Market efficiency A simple economy Testable predictions Description of the IEM Traders are irrational Traders are irrational: Arbitrage opportunities in the lab Traders are irrational: Arbitrage opportunities on the IEM Traders are irrational: Arbitrage opportunities on the IEM Traders are biased Endowment effects in the lab: Dependence of portfolio on endowment Wishful thinking in the lab: Relative price movements Previous Evidence on the False Consensus Effect IEM Evidence on the False Consensus Effect IEM Evidence on the Assimilation-Contrast Effect Market prices are strange in the lab Baseline Markets Market prices are efficient in the IEM Duration Caps on Arbitrage Violations Inter-temporal pricing efficiency: Work on the computer industry markets IEM prices display predictive efficiency IEM prices display predictive efficiency The question: How do we reconcile this? Marginal traders as less subject to the false consensus effect Queues protect traders The quandary We donít understand: Complex systems may help us understand: Market Efficiency and Trader Rationality

Author: Thomas A. Rietz Department of Finance University of Iowa Thomas Rietz earned his Ph.D. in economics at the University of Iowa and served on the faculty at Northwestern University prior to returning to the University of Iowa as a faculty member in the Finance Department in 1993. Professor Rietz has received several research awards and authored a number of academic articles published in many prestigious journals. Professor Rietz uses a combination of theoretical, empirical and experimental work to address his two primary research areas: 1) financial markets and decisions and 2) elections and voting decisions. Currently, he has served as the section head for finance on the executive committee of the Economic Science Association, the professional organization for experimental economists. Recently, Professor Rietz was appointed to the interdisciplinary Preferences Network Risk Research Initiative of the MacArthur Foundation. Professor Rietz is an Iowa Electronic Markets (IEM) manager and uses the IEM in both research and teaching. Professor Rietz regularly teaches Introductory Financial Managment to undergraduates and Financial Management to MBA students. He also teaches Investment Management and Commercial Banking periodically. He regularly teaches on the Iowa Communications Network and recently published an initial study of its effectiveness as a teaching vehicle.