Correlated Mistakes and the Failure of Arbitrage
In Chapter 5, we examined how individual decision making is oftentimes irrational and prone to various behavioral errors. This is in clear violation of the first theory underpinning the broader notion of market efficiency but certainly does not close the case on market efficiency. Recall from Chapter 3 that the notion that markets are efficient does not live and die strictly at the hands of the individuals that comprise the market. In short, market efficiency is predicated on three theories:
- Individuals are rational beings that make self-interested choices.
- In cases where individuals behave irrationally, their errors are canceled out by others who take an opposing viewpoint. In other ...