Trading and Exchanges Chapter 10: Market Efficiency and Why It's Not Perfect (Part 2)
In Part 1 we covered the four types of informed traders: value traders, news traders, technical traders, and arbitrageurs. Now we get to the really good stuff. What happens when all these informed traders compete? How efficient do prices actually get? And why can markets never be perfectly efficient?
This is where Harris drops one of the best paradoxes in all of finance.
Where Do Informed Trading Profits Come From?
Informed traders cannot make money trading only with each other. Trading is a zero-sum game. If all participants are informed, the winners cancel out the losers. Eventually losers quit. Then the next weakest group quits. Keep going and you end up with one genius sitting alone with nobody to trade against.
So informed traders need uninformed traders. Investors, hedgers, people moving money for practical reasons. These folks lose a bit on average, but they tolerate it because they get valuable services from the market. Retirement investing, risk hedging, asset exchanges. The losses to informed traders are basically a tax on using the market.
Naturally, uninformed traders try to figure out who is informed so they can avoid them. Informed traders respond by hiding, trading anonymously, pretending to be regular investors. Cat and mouse game baked into every market.
The interesting outcome: markets with lots of uninformed traders attract lots of informed traders competing for profits. More competition pushes prices closer to true values. Paradoxically, uninformed traders individually lose less because prices are already pretty accurate.
The Grossman-Stiglitz Paradox
This is my favorite part of the chapter. Harris describes what economists call a market paradox, and it goes like this.
If prices perfectly reflect all available information, then no informed trader can make money. But if no informed trader can make money, they all quit. If they all quit, nobody is pushing prices toward true values. So prices stop reflecting information. Which contradicts our starting assumption.
See the loop? Perfect efficiency destroys the incentive to make markets efficient.
The resolution is elegant. Markets are never perfectly efficient at all times. What actually happens is a cycle. Prices drift away from fundamental values because new information arrives or uninformed traders push prices around. Informed traders spot the gap and trade. Their trading pushes prices back toward true values, eliminating the profit opportunity. Then the cycle repeats.
There is always a small gap between price and value, and that gap is what pays informed traders for their work.
The Three Levels of Market Efficiency
Financial economists came up with three formal definitions to describe how efficient markets are.
Weak-form efficient means prices already reflect everything you can learn from past prices. If this holds, staring at charts and running statistical analyses on historical price data is useless. Prices look like a random walk. Most academic research says markets pass this test. Though Harris makes a sly note: if researchers found chart patterns that actually worked, they would probably trade on them instead of publishing papers about them.
Semi-strong-form efficient means prices reflect all publicly available information. News, financial reports, economic data, everything public. You cannot beat the market using only public info. Evidence suggests markets are generally semi-strong efficient for information that is easy to get and interpret.
Strong-form efficient means prices reflect everything, including private information. This basically never happens in interesting markets. The only strong-form efficient market Harris can think of is trading five-dollar bills for one-dollar bills. Everyone knows a five is worth five ones. Not exactly an exciting trading opportunity.
Harris then offers a better, more modern definition. An efficient market is one where prices reflect all information that traders can acquire and profitably trade on. This definition accounts for real-world costs: research is expensive, trading has transaction costs, and moving prices has impact costs. Information only gets into prices when someone can afford to put it there.
The Tradeoff Nobody Talks About
Here is something regulators struggle with constantly. Informative prices are incredibly valuable for the economy. They help businesses make good production decisions and help capital flow to the right places. But informative prices are not free. The cost is paid by uninformed traders who lose money to informed traders.
This creates a genuine tension. Policies that restrict informed traders (like insider trading rules) protect uninformed traders and improve liquidity. But they also make prices less informative.
Harris argues there is one policy that helps both sides: requiring companies to publish material information. When information is public, prices reflect it quickly without informed traders needing to extract profits from uninformed ones. This is why exchanges require regular financial reports.
The USDA takes this seriously. Their statisticians prepare crop reports overnight in locked rooms with no phone or internet. Data arrives encrypted, decrypted only after lockdown. All so orange juice futures traders cannot get a two-minute head start. If you have seen Trading Places, you know exactly why this matters.
The Bottom Line
Markets are efficient enough that casual speculation is a losing game. But they are never so efficient that there is no room for informed traders. The gap between “efficient enough” and “perfectly efficient” is where the entire informed trading industry lives.
If you are thinking about speculating, Harris has one piece of advice: seriously ask yourself why you expect to be successful. The most common mistake is trading without a comparative advantage. We will revisit that in Chapter 22.
Previous: Chapter 10: Informed Traders (Part 1)