Inefficient Markets
Summary
Shleifer presents behavioural finance as a research programme rather than as a collection of anomalies. His central theoretical contribution, developed with Robert Vishny, is the limits of arbitrage argument, which explains why mispricing persists even when sophisticated investors identify it.
The standard defence of market efficiency holds that rational arbitrageurs will correct any mispricing caused by irrational traders. Shleifer shows this fails under realistic conditions. Arbitrage requires capital, and professional arbitrageurs manage other people's money. When a mispricing widens against them, they suffer losses, their investors withdraw capital precisely when the opportunity is best, and they must liquidate rather than add. This means arbitrage capacity is smallest exactly when mispricing is largest. He adds that most real arbitrage is not riskless because close substitutes rarely exist, and that the horizon required may exceed what any fund can survive.
The empirical chapters cover closed-end fund discounts, which cannot be explained by any efficient market account, the equity premium, momentum and reversal, and the internet period, alongside the investor sentiment model he built with De Long, Summers and Waldmann.
The book is written for economists and requires the mathematics. Its argument has become standard and the limits of arbitrage framework is now used across finance. For investors the practical implication is direct: identifying a mispricing is insufficient, and the question of whether you can hold the position long enough to be paid determines whether the trade exists. The empirical material is now dated.
Key takeaways 7
- Mispricing persists because arbitrage is limited by capital, not because sophisticated investors fail to see it.
- Professional arbitrageurs manage other people's money, and their capital is withdrawn precisely when the mispricing has widened and the opportunity is best.
- Arbitrage capacity is smallest exactly when mispricing is largest, which is the reverse of what efficient market theory assumes.
- Real arbitrage is rarely riskless because close substitutes for a mispriced security usually do not exist.
- Closed-end fund discounts cannot be explained within any efficient market framework and vary with a common factor consistent with investor sentiment.
- Investor sentiment moves prices systematically rather than randomly, which means noise trader risk is itself a priced risk.
- Identifying a mispricing is insufficient for a trade, since whether you can hold the position long enough to be paid determines whether the opportunity is real.
Who should read it
Investors and finance students who need the theoretical account of why mispricings persist and what that implies for holding contrarian positions.
Where it sits in the reference 3
Who recommended it 1 · 1 direct
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