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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 5 / 23





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an investment strategy that offers riskless profits at no cost. Presumably, the rational traders in Friedman’s fable became known as arbitrageurs because of the belief that a mispriced asset immediately creates an opportunity for riskless profits. Behavioral finance argues that this is not true: the strategies that Friedman would have his rational traders adopt are not necessarily arbitrages; quite often, they are very risky.

An immediate corollary of this line of thinking is that “prices are right” and “there is no free lunch” are not equivalent statements. While both are true in an efficient market, “no free lunch” can also be true in an inefficient market: just because prices are away from fundamental value does not nec- essarily mean that there are any excess risk-adjusted average returns for the taking. In other words,

“prices are right”

“no free lunch”


“no free lunch” “prices are right”.

This distinction is important for evaluating the ongoing debate on mar- ket efficiency. First, many researchers still point to the inability of profes- sional money managers to beat the market as strong evidence of market efficiency (Rubinstein 2001, Ross 2001). Underlying this argument, though, is the assumption that “no free lunch” implies “prices are right.” If, as we argue in sections 2.2 and 2.3, this link is broken, the performance of money managers tells us little about whether prices reflect fundamental value.

Second, while some researchers accept that there is a distinction between “prices are right” and “there is no free lunch,” they believe that the debate should be more about the latter statement than about the former. We dis- agree with this emphasis. As economists, our ultimate concern is that capi- tal be allocated to the most promising investment opportunities. Whether this is true or not depends much more on whether prices are right than on whether there are any free lunches for the taking.

2.2 Theory

In the previous section, we emphasized the idea that when a mispricing oc- curs, strategies designed to correct it can be both risky and costly, thereby allowing the mispricing to survive. Here we discuss some of the risks and costs that have been identified. In our discussion, we return to the example of Ford, whose fundamental value is $20, but which has been pushed down to $15 by pessimistic noise traders.

Fundamental Risk. The most obvious risk an arbitrageur faces if he buys Ford’s stock at $15 is that a piece of bad news about Ford’s fundamental value causes the stock to fall further, leading to losses. Of course, arbitrageurs

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