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It is often assumed that share prices automatically consider all available information since if some market participants have more information that implies that a share is, for example, underpriced, they will buy the share and the price will increase due to the increased demand.

But which fraction of the market participants is well-informed and rational? If enough (e.g. one third) are not well-informed, wouldn’t that imply that the other two thirds could earn money by buying / selling stocks to the other third which would lose that money? And therefore the well-informed participants would outperform the stock market while the rest would underperform compared to the average market performance?

Is this an effect that is relevant in reality? I.e. is there a significant fraction of market participants that is not well-informed and do they actually perform worse than the market performs on average?

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    If the market were rational, stuff like the 2008 crisis would not have happened. Ergo: it's an insignificant amount
    – Hobbamok
    Commented May 25, 2023 at 19:41
  • Which market? Broad western large-cap indexes, sure, most of the holders will be informed institutional investors and the over-informed are excluded by insider trading laws. Meme stocks, you gotta wonder.
    – Rich
    Commented May 26, 2023 at 3:18
  • One word: WallStreetBets
    – RonJohn
    Commented May 26, 2023 at 3:58
  • 2
    which fraction of the market participants is well-informed and rational — zero?
    – gerrit
    Commented May 26, 2023 at 7:12
  • Congratulations, you have discovered the business model of most trading companies that operate in publicly accessible markets. Especially those in completely unregulated markets, such as crypto, where upward of 95% of the market volume is completely uninformed rando's on trading apps.
    – user123255
    Commented May 27, 2023 at 9:29

9 Answers 9

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Individual Investors are a Minority

Institutional investors own about 80% of the stock market, leaving retail investors as the remaining 20%.

Since their day job is investing, institutional investors are presumably well informed about market conditions.

It was tough to find a further breakdown, but this was close. It points out that about 15% of the stock market is index funds, which aren't actively managed.

So by value the market looks something like 65% professional traders, 20% individuals, and 15% robots.

Presumably some of those individuals are well informed, so it's likely that enough traders are well informed enough that the "everyone knows everything that is public" ideal is more or less true.

The Exceptions

There are some "retail investors" who are very, very wealthy. Virtually all of Elon Musk's wealth is in Tesla stock, and he doesn't count as an "institutional investor." So there's definitely the potential for rich individuals to not know - or willfully ignore - public information and create a pricing disparity between what they think and what the rest of the market "knows."

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If enough (e.g. one third) are not well-informed, wouldn’t that imply that the other two thirds could earn money by buying / selling stocks to the other third which would lose that money?

Where do you put the people who are not well-informed, but don't care because they are invested in index funds?

Where do you put the people who are not well-informed but don't care because they are invested in an active fund?

Where do you put the people who aren't well informed but don't care because the stocks are owned by their pension fund?

These people are comfortable not being well informed about the individual companies. They are invested in an index, or they are counting on experts making the decisions.

I think that outside of meme stocks the big money is in slow moving funds that aren't trying to time the market.

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    This answer would be much more interesting with numbers.
    – codeMonkey
    Commented May 25, 2023 at 17:11
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    Aren't these people completely irrelevant to the question? The entities owning the stocks in these cases are the funds, not these people, and I'd guess that the people managing the funds are well-informed. So, taking for example the case in the question, "the other two thirds could earn money by buying / selling stocks to the other third", it's not possible for the first two thirds to sell to these people because they aren't the ones buying or selling anything.
    – muru
    Commented May 26, 2023 at 5:49
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Not being well informed does not automatically mean willing to pay stupid prices. If you tried to take advantage of this, they'd just buy from all the people who were willing to sell at more reasonable prices. Everyone would have to agree to demand more at once, and then you'd get hit with stock manipulation charges... or the price would have to genuinely go up.

The system really is mostly self correcting, simply due to competition among buyers and sellers.

There are no shortcuts on individual stocks. If there were, folks would already be taking advantage of them and the market would be working to correct them.

The real shortcut is understanding that the market as a whole trends upward, and taking market rate of return rather than spending huge amounts of effort trying to do better than that average.

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  • The market price is not a reflection of all available information. It is a weighted average of the beliefs of all market participants. If a large proportion of market participants holds incorrect beliefs, then the market price does not accurately reflect all available information. This is exactly what this question is about. This may at some point be corrected by the market, but it is precisely the process of correcting that allows 'better-informed' market participants to make a profit. Oddly, many market participants believe that they are better-informed, even though they do not all agree...
    – user123257
    Commented May 27, 2023 at 10:34
  • That's not untrue, but it's an edge case. Most market profit comes from the fact that most businesses make a profit. The fact that simple diversification can yield market rate of return with near zero knowledge is sufficient proof of that.
    – keshlam
    Commented May 27, 2023 at 12:33
  • (It's been working fine for me for decades now. Current APR for past 5 years stands 7.5% and rising, and I have paid zero attention to individual stocks and only the most cursory attention to the market as a whole -- five categories, five index funds, one target mix over most of that time and one change to that target when I retired, rebalance once a year or whenever I get more than 1% away from that balance, near-zero attention to what the market is doing. Special knowledge: Knowing what I don't know, and knowing I don't have to care.)
    – keshlam
    Commented May 27, 2023 at 14:00
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One can answer your final question indirectly. The not well-informed investors would probably mostly be individuals with small investments so measuring their performance directly is hard. However, if there was a significant proportion of market participants who perform worse than average in the long run, then there would also have to be a significant group of market participants who perform better than average in the long run.

Now every actively managed fund tries to convince you that this is exactly their business modell but long term statistics show this is not true on average. The collection of actively managed funds in the long run performs exactly as well as the market as a whole. Therefore possibly there are individuals who underperform the markets in the long run but they is no significant proportion of market participants who underperform.

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This would be a significant factor if most investors made their own investment decisions. But that's not the case.

First of all, only around 50% of Americans are invested in the stock market at all. I don't have citations to back it up, but I think it's a reasonable guess that they tend to be people who are more informed about finances.

Second, most of them don't are not invested directly in individual stocks that they need to research. About two thirds of the stock market is owned by institutional investors: mutual funds (and similar entities like variable annuities and ETFs), pension funds, and endowments. Most individuals invest indirectly through mutual funds, which employ professional fund managers and research teams. They can be assumed to be well informed. Of course, they don't all have exactly the same information, and economics is not an exact science so they can draw different conclusions from the information they have. Furthermore, mutual funds have specific investment objectives; some are targeted towards particular industries, others to different styles (e.g. long-term growth versus income-producing dividends, or stocks versus bonds), which limits their ability to act on some information (a stock fund can't shift to bonds when there's a bear market).

And even people who invest directly don't necessarily have to do their own research. Wealthy investors will frequently hire a money manager to advise them.

There will still be some who invest with little knowledge and can be taken advantage of. When I was first starting out investing, I got a cold call from an investment firm (the infamous First Jersey Securities) that convinced me to buy a penny stock. Luckily I mentioned it to my father, who recognize the scam, and I was able to pull my money out before I lost anything. But while this can potentially be lucrative to the scammers and disastrous to the small investors who get taken in, it won't have a noticeable effect on the broad market. As an analogy, car theft has negligible impact on the commercial car market.

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Core Answer

What you are referring to is the Efficient Market Hypothesis (EMH).

It's good to understand that there are generally three forms of this idea:

  • Strong: All private and public information is reflected in current stock prices
  • Semi-strong: All public information is reflected in current stock prices
  • Weak: All historical price information is reflected in current stock prices

Without delving into the technical details of these three ideas, the idea is that markets are effective at price discovery and that the idea that you can find a stock that is mispriced and gain from that 'arbitrage' is impossible or at least infeasible.

You didn't ask if the theory is correct so the direct answer to your question of whether this idea assumes or requires that most participants of the stock market are well-informed is: not exactly.

For one, the weak and semi-strong forms of the hypothesis allow for private information e.g.: insider information to not be reflected in the price. I think we can safely assume that most people don't believe insider information is reflected in stock prices. There are laws against insider trading precisely for this reason. The insider selling or buying something that they know is worth less or more than the majority of market players.

Even beyond that, all of these really only require that there enough informed players to move the price to its correct level. It's also important to realize that all market players do not have the same ability to move a stock price. It's not a one person: one vote system. The average investor cannot move a stock price as much Warren Buffet can, for example.

Aside

This has always been my problem with the strong and semi-strong forms: the way that the price moves people are buying and selling based on a discrepancy between the price and the real value. But if the price were already correct, how could that happen? The obvious answer is 'new information' but again, once that new information comes out, there's some period of time when the related stocks have their old (wrong) price. In other words, the way markets discover prices is: when there's a mispriced stock, players will take advantage of that until that discrepancy is resolved which is exactly what the strong and semi-strong theories say can't happen. If the price were always correct, there would be no need for price discovery which is how prices become correct.

In short, other than maybe a few out-of-touch academics, no one really believes this literally true, but I think many people believe it is roughly true over time, as I do.

Homo Economicus

You may be asking this because there's an idea in economics that humans are purely rational actors with regard to markets and other financial matters. The problem with this idea is that it's known to be empirically false based on many repeatable experiments. One of the main reasons this assumption was used is that it makes the mathematics so much easier. We've only begun to have the kind of computing power required to deal with economic theories that reflect real human behaviors.

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There is an extremely important interdisciplinary paper https://arxiv.org/pdf/1002.2284.pdf : "Markets are efficient if and only if P = NP"

This links information theory and economics together. "P=NP" is generally considered to be an unsolvable computing problem; that is, there is an upper limit on how efficiently information can be processed.

That is, for some values of "all information", it may be impossible for everyone to have considered all the information. Especially in a reasonable time.

Is this an effect that is relevant in reality? I.e. is there a significant fraction of market participants that is not well-informed and do they actually perform worse than the market performs on average?

Yes. Just as there's usually a least-informed player round every poker table. Not just day traders, but various small institutional investors. Conversely, high-frequency traders attempt to get as much information as possible as fast as possible in order to win a margin.

However, this doesn't mean that the less-informed always lose money, they might just not make as much money as a more-informed trader, and information gathering and processing is in itself a cost which must be subtracted from your winnings.

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    First, nobody knows if P=NP, last I heard. Second, that argument is only valid if you are asking for perfect efficiency; nobody has ever claimed that, only that it comes close enough that opportunities to reliably rale advantage of the difference without violating SEC rules are few and far between. In theory, practice is identical to theory; in practice, not so much.
    – keshlam
    Commented May 25, 2023 at 11:26
  • The question of whether P = NP is not "generally considered to be an unsolvable computing problem". It's just an unsolved problem.
    – kaya3
    Commented May 26, 2023 at 10:22
  • @kaya3 Actually, I have an ingenious semi-proof that P != NP. I think it's really only feasible to prove P=NP (or not) rigourously iff P=NP, which it's not, which is why nobody has come up with a rigourous proof.
    – Andy
    Commented May 26, 2023 at 19:29
  • "rale", of course, was supposed to be "take". Thank you, autodefect.
    – keshlam
    Commented May 27, 2023 at 22:44
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That is relevant in reality? Yes.

The others answers already address the title question, about if most market participants are well/better informed. There I will focus on the last part.

Is this an effect that is relevant in reality? I.e. is there a significant fraction of market participants that is not well-informed and do they actually perform worse than the market performs on average?

Yes, it is. The Fidelity Magellan Fund natural experiment somewhat demonstrated that market participants that buy high, sell low, actually underperform in relation to a profissional, well-informed participant.

While the Fidelity Magellan Fund returned 29% from 1977-1990, the average fund investor lost money during this time period.

This argument is associated with timing the market or not, but here we got a good example where it is easy to identify the results of an assumed better informed market participant (the fund), versus the assumed worse informed market participant (the fund investors).

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  • If you buy high and sell low then of course you underperform. But that isn't the only alternative to trying to fully understand the market. Since you gave a citation, I'll cite the Buffet Bet, which demonstrated that after fund overhead is subtracted out, index funds were doing as well as managed funds.
    – keshlam
    Commented May 28, 2023 at 2:30
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Making bad trades is as hard as making good trades.

(With the exception of trading fees or illiquid stocks. Basically assuming you could choose to either buy or sell with the same terms.)

Anyone can be randomly correct or incorrect in their predictions of the development of a particular stock. To perform better than market average, you need to be consistently correct. If you are consistently incorrect, just reverse your strategy.

If someone is great, the average of the rest is necessarily worse

If there is a superstar trader who has consistent better-than-average performance, then just by simple mathematics, the average of all other traders is slightly below the average that includes the superstar. But it doesn't require that any single trader is significantly worse, it just means they are all slightly worse by average.

If a trader is consistently correct, their influence will grow

What about the share price? It is affected most by traders who make most trades. And the more money and profit you have, the more and larger trades you are able to make in the long run. If there are significant differences in trader performance, the better ones should end up having more influence on share price.

Being well-informed does not exclude being wrong

There will always be situations where a significant fraction of traders is found to have been misinformed in retrospect, and the stock price suddenly changes when new information is widely accepted. Information being accepted by a large amount of traders is the best proxy for being "well-informed" that we have, but the information can still be wrong.

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  • Making bad trades is very easy. For instance, try and buy a large amount of an unpopular, non-hyped asset. The price you pay will be above market due to high demand, but no one's going to buy if off you at that price. You're simply gifting money to the company and/or its other shareholders.
    – Therac
    Commented May 25, 2023 at 15:44
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    Making bad trades ... in a liquid market is hard. If you aren't worth many millions and you aren't buying fringe stocks, the market liquidity is going to be basically infinite in what you buy.
    – Yakk
    Commented May 25, 2023 at 18:29

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