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The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias Ronald J. Gilson Reinier Kraakman, Harvard Law School Download the Paper (PDF format) - November 29, 2003 Tell a colleague about it. Printing Tips: Select 'print as image' in the Acrobat print dialog if you have trouble printing. 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. SUGGESTED CITATION: Ronald J. Gilson and Reinier Kraakman, "The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias" (November 29, 2003). Harvard Law School. Harvard Law School John M. Olin Center for Law, Economics and Business Discussion Paper Series. Paper 446. http://lsr.nellco.org/harvard/olin/papers/446 | REPOSITORY HOME  | SEARCH  | MY ACCOUNT  | NELLCO HOME | Powered by bepress.