A few weeks ago, some managers at VW knew that the company was exposed to the risk of big fines and a loss of reputation and so its share price was too high. Shareholders did not know this. There was asymmetric information between some insiders and outsiders.
Glencore's share price has fallen by 80 per cent since it was floated in May 2011. This conforms to a pattern for newly issued shares to do badly in the months after flotation. Jay Ritter at the University of Florida has estimated that, in the US, newly floated companies since 1980 have underperformed the market by an average of 18.6 per cent and much the same is true for the UK and other countries. Again, asymmetric information is a reason for this. Owners know more about their business than outside investors, and they use this superior knowledge to sell it at a high price. This advantage need not be that they have hard information about the accounts or business prospects. Instead, it's likely to be a gut feel or hunch based upon years of experience which tells them that 'this is roughly as good as it's going to get': that oxymoronic phrase 'knowledge management' overlooks the importance of tacit knowledge.
Herein, though, lies a puzzle. We have a theory about asymmetric information, for which its inventor George Akerlof won a Nobel prize, and this theory is elegant, logical - and wrong.
Consider the used car market, he said. Some cars are for sale because their owners have grown tired of their endless faults: Americans call these lemons. Other cars, though, are good. Potential buyers, however, cannot easily distinguish between the good cars and the lemons; the latter can be patched up to seem good for a while. Knowing that there's a risk of getting a lemon, buyers will not want to pay the price they would if they could be certain the car was good. Good cars can therefore only be sold at a discount. But this means that owners of good cars will get a lousy deal and so will take them off the market. Only lemons will then remain. And knowing this, buyers will be put off. The upshot, said Akerlof, will be that "no market exists at all".
This prediction, though, is wrong. There are very lively markets in goods and assets despite the existence of information asymmetries.
In many cases, this is easily explained. Warranties and guarantees offer peace of mind to uninformed car buyers. And in other markets, reputation does so: on eBay for example, sellers' earn stars for delivering satisfactory goods.
However, these institutions are missing in equity markets and yet there is still intense trading. I fear that this is because of overconfidence. Unlike Akerlof's car-buyers, traders simply don't know that they are at an informational disadvantage and so trade as if they were informed. This means they can and do trade upon fictions: 'VW is a reliable company', 'Glencore has great prospects', and so on. This can cause shares to be overpriced. And there will often be little that rational but ill-informed traders can do about this, simply because as Maynard Keynes said, "markets can remain irrational for longer than you can remain solvent".
For me, this is one (more!) reason why I confine myself to tracker funds. I do so not because I believe the market is efficient, but because doing so offers me at least partial protection from being a victim of my own ignorance.
