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The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias


Ronald J. Gilson


Stanford Law School; Columbia Law School; European Corporate Governance Institute (ECGI)

Reinier Kraakman


Harvard Law School; European Corporate Governance Institute

October 2003

Columbia Law and Economics Working Paper No. 240; Stanford Law and Economics Olin Working Paper No. 270; Harvard Law and Economics Disc. Paper No. 446

Abstract:     
Twenty years ago we published a paper, "The Mechanisms of Market Efficiency," that sought to describe the institutional underpinnings of price formation in the securities market. Since that time, financial economics has moved forward on many fronts. The sub-discipline of behavioral finance has struggled to bring yet more descriptive realism to the study of financial markets. Two important questions are (1) how much has this new discipline changed our understanding of the efficiency and nature of the institutional mechanisms that set price in financial markets; and (2) how far does this discipline carry novel implications for the regulation of financial markets or corporate behavior more generally? We argue that, despite its heavy reliance on the psychology of cognitive bias, the principal contribution of behavioral finance is to enrich our understanding of market institutions rather than to present us with a fundamentally new paradigm of market behavior. In particular, the cognitive limitations of individual investors or noise traders are likely to matter to pricing behavior to the extent that they interact with - and are not offset by - the arbitrage mechanism in the market. The most important contribution of behavioral finance lies in sharpening our understanding of the limitations of the arbitrage mechanism. Even when cognitive bias does not have clear implications for securities prices, however, it may have important implications for policy. These implications are unlikely to arise in the area of corporate takeovers, as some have claimed, but they do arise in areas akin to consumer protection, as where cognitive bias might lead unsophisticated investors to construct dangerously undiversified retirement portfolios.

Number of Pages in PDF File: 48

JEL Classification: G140, G390

working papers series


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Date posted: November 7, 2003  

Suggested Citation

Gilson, Ronald J. and Kraakman, Reinier, The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias (October 2003). Columbia Law and Economics Working Paper No. 240; Stanford Law and Economics Olin Working Paper No. 270; Harvard Law and Economics Disc. Paper No. 446. Available at SSRN: http://ssrn.com/abstract=462786 or http://dx.doi.org/10.2139/ssrn.462786

Contact Information

Ronald J. Gilson (Contact Author)
Stanford Law School ( email )
559 Nathan Abbott Way
Stanford, CA 94305-8610
United States
650-723-0614 (Phone)
650-725-0253 (Fax)
Columbia Law School ( email )
435 West 116th Street
New York, NY 10025
United States
212-854-1655 (Phone)
212-854-7946 (Fax)
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
Reinier H. Kraakman
Harvard Law School ( email )
1575 Massachusetts
Hauser 406
Cambridge, MA 02138
United States
617-496-3586 (Phone)
617-496-6118 (Fax)
European Corporate Governance Institute ( email )
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
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