Discussion Paper Week 5: What Causes Market Inefficiency - Assignment Example

Running head: Market Inefficiency Market Inefficiency s Market Inefficiency Market Inefficiency This is the condition where the availability and access to information is unequal or the usage is not efficient. For example, some investors have more information about the overall market or any particular security while others having less, also some individuals not analyzing the market condition properly as compared to some others.
This kind of inefficiency mostly occurs when stock prices do not shadow the available information about them. The glitch is termed as market inefficiency which can occur even if the individuals are unable to apply certain information that they have access to. For instance, in the case of an investor mistaking and placing the value of some firm’s prospective revenue at too low a number, there might be the occurrence of market inefficiency; read in other reads, it means that the interpretation on the part of the investors regarding the stocks of the firm may be worse investments as compared to what they are in real, which may result in market inefficiency. A lot of the investors try using market inefficiency such that they are able to take advantage of it. A renowned investor Warren Buffet makes the claim of his accumulating his fortune owing to market inefficiency. Regarding market inefficiency, Warren Buffet has stated, “Id be a bum on the street with a tin cup if the markets were efficient”.
The main concern behind this is that market forces (external forces) usually tend to drive stock prices up or below their true value. Same applies to other types of assets as well. This can easily supported with the trend line of market productivity which unexpectedly sometimes collides down or spears up. All this happens due to some unseen and unanalyzed market forces that tend to affect values and prices of assets.
Usually market inefficiencies do exist. Some are structural in nature others are transitory and tend to wane away as soon as they have been discovered. The fact that the market tends to move securities to their original worth and value, explains that a security will no longer remain undervalued or overvalued. This is why that we see market prices changing too rapidly and matching a stock’s or an asset’s original value. An efficient market usually avoids the incompatibilities between values as well as prices of securities and improper access to information for all the investors. This supports the proposition that in an efficient market every investor has equal access to complete information.
Some analysts also argue in support of existence of market in efficiency and say that inefficiencies exist else there would not have been a dotcom disasters in late 90’s and some other examples of market crashes.
Example of Market Inefficiency
A clear example of market inefficiency was seen in the year 2000 when 3Com (producer of computer network infrastructure), ticker cosmos, which is renowned for its Palm Pilot (smart phone manufacturers) held the personal organizer and divided the Palm Pilot from the company to create a separate division. In the month of March, palm pilot offered 6 percent of the company in initial public offering.
On that day’s closing prices, the market valued all of Palm Pilot at $53.4 billion.  But it valued all of 3Com at “only” $28 billion, which means ninety four percent of 3Com was valued at $50 billion.  So, it perceived the part of 3Com and excluding Palm Pilot at negative $22 billion.  However, financial analysts estimated the value of this total sum was between $5 billion and $8.5 billion. Within six months or so, 3Com planned to distribute these Palm Pilot shares (ticker PALM) to its shareholders. One could buy Palm Pilot directly in the market at a worth of $53.4 billion or buy Palm Pilot at a worth between $19.5 billion and $23 billion through buying COMS (3 COM Corporation).
Solutions to Market Inefficiencies
There can be following solutions of market inefficiencies:
Make sure that complete and proper information is available for every investor
Try to eliminate the inefficiency even before the market does itself
Manage the supply and demand according to the need in the market and not according to the level of profits (although indirectly the former one gets transformed into the later one)
Money laundering is also one of the reasons that local market crashes down, so there should be proper measures for such cases as well
Try to avoid and eliminate money laundering even before it has actually affected the stock market and prices
Financial institutions like banks and foreign exchange institutions should be kept in check of their reserves of foreign currency.
References
Can amrket inefficiencies be exploited? (n.d.). Retrieved Feb 4th, 2010, from Money watch.com: http://moneywatch.bnet.com/investing/blog/wise-investing/can-market-inefficiencies-be-exploited/498/
Reflections on market inefficiencies. (n.d.). Retrieved Feb 4th, 2010, from jstor.org: http://www.jstor.org/pss/4478640
What is an inefficient market? (n.d.). Retrieved Feb 4th, 2010, from Investopedia: http://www.investopedia.com/terms/i/inefficientmarket.asp Read More