I heard a wonderful example of a surprisingly efficient market the other day on NPR’s Planet Money blog.
The post (found here), titled ‘Textbook Arbitrage: Making Money Off Used Books’ tells the story of two entrepreneurs that sell books, t-shirts and other assorted goods on Amazon.
A little while back, they noticed that the price of college textbooks were more volatile than they would have expected.
Better yet, the prices were seasonal and relatively predictable: used textbooks are cheap in the summer when kids are having some summer fun and expensive in the fall when they’ve picked their classes and need the books.
The two business people bought $10,000 worth of textbooks and have doubled their money thus far simply buying books in the summer and selling them in the fall.
The story concluded by saying that ‘the thing about free money opportunities is that they tend not to last very long, precisely because everyone is looking for them.’
They make the point that if a larger player gets into their market, you won’t be able to buy them for $4 anymore or sell them for $200 – the price gap will close with competition.
I love that story, because it’s so simple and it really tells the story of why stock prices are relatively (though not perfectly) efficient.
Unlike the used textbook market, the stock (or bond) market is huge, has millions of participants constantly evaluating prices and seeking out inefficiencies like the one in the story.
There’s a lot of competition in markets, even the supposedly inefficient corners like small cap, emerging markets or distressed debt. That competition creates efficiency.
There are some anomalies, like buying cheap stocks (value), but that’s not a free lunch, unlike the ‘textbook trade’ described in the story.
This year, for example, value stocks are underperforming the overall market, but seasonal textbook prices are a sure thing without competitive market participants.