Experimental research illustrates the mechanics of market inefficiency. If information is costly traders will only procure it to the extent that markets are seen as inefficient. In particular, when observing others’ investment in information, traders will cut their own information spending. Full information efficiency can never be reached. Moreover, business models that invest heavily in information may have higher trading profits, but still earn lower overall profits due to the costs of improving their signals. What seems crucial is high cognitive reflection so as to invest in relevant information where or when others do not.

Corgnet, Brice , Cary Deck, Mark DeSantis, and David Porter (2017), “Information (Non)Aggregation in Markets with Costly Signal Acquisition”,  GATE Working Paper 1735 – December 2017

The post ties in with SRSV’s lecture on market information inefficiency.
The below are excerpts from the paper. Emphasis and cursive text have been added.

The limits of market efficiency

“The notion that markets aggregate private information has been put forward since Hayek (1945)…Experimental results [of academic studies in the 1980s]…suggest that markets do aggregate individual traders’ disparate information…In fact, the evidence of markets aggregating information is sufficiently strong that a large group of scientists called for the relaxation of various laws to facilitate greater use of prediction markets.”

[However], informational efficiency in the market reduces the benefit from acquiring information…if markets are completely efficient so that prices fully reflect all information held by traders, then one would never incur a cost to acquire new information solely for the purpose of trading as the cost of the information could not be recovered. The implication is that no trader would seek out costly information and thus such information could not be reflected in the price. The costly collection of information requires that markets either do not fully reflect all available information or only do so gradually [as pointed out in a famous paper by Grossman and Stiglitz in 1980]

“[Academic research in the 2000s and 2010s] has shown that, in a [experimental] market design, asset prices are not fully informationally efficient.”

Findings from market experiments

“This paper provides a systematic examination of information aggregation in centralized markets in which traders can obtain costly signals of an asset’s value. We want to assess how well market prices reflect aggregate information and reveal the underlying value of the asset when information is costly…This paper uses controlled laboratory experiments to investigate the puzzle of information aggregation when information is costly. Data were collected for a total of 240 subjects from six different experimental treatments that varied the cost of information and the amount of information that traders could acquire.”

“[In the experiment]…traders purchase signal. The lower the cost of signals, the more signals traders will buy. Given a cost per signal, the more precise a signal, the more signals traders will buy…Providing feedback that others are acquiring information, which reduces the maximum benefit of acquiring information, will lead to less information being acquired.…The results also indicate that the amount of information purchased does not decline dramatically with experience…that trade volume is not correlated with the underlying value of the asset, but it is inversely related to the number of signals acquired. “

“The results clearly indicate that absolute price error is diminishing [when information is acquired]…more information acquisition will lead to greater informational efficiency…[However,] overall, our findings indicate that market prices do not perfectly reflect the underlying value of the asset in line with the recent works [of other researchers]…Prices [in experimental trading] do not closely match asset value. The observed…prices [in subsequent trading sessions] are fairly flat and even the [trading sessions] that have the most information still do not come close to approaching prices [of the high and low end of a given range]…when those are the true values of the asset.”

“The lack of full information aggregation implies that acquiring costly information may be profitable to a trader.”

“The fact that market prices do not equal the true value of the asset does not mean prices do not provide any information about the underlying value of the asset.”

“The average market price can convey information when traders can acquire costly information. This is an important but subtle point. Viewed in isolation the average price in a market may not be informative. However, once the central tendencies of a market are identified then minor changes in price patterns can reveal substantial insights into the traders’ private signals.

The importance of cognitive reflection

“The low level of informational efficiency of markets implied that private signals had a positive value. However, when studying individual behavior, we observe that information acquisition was counterproductive as those who did acquire more signals increased trading profits while decreasing their total profits…Traders…acquire an excessive number of signals thus harming their overall profits.”

“At the individual level, those with higher cognitive reflection scores and those with higher theory of mind scores tended to earn greater trading profits and total profits than those with lower scores.”

“Information share is the number of signals purchased by a trader divided by the total number of signals purchased in the market period…The positive… and highly significant… relationship between information share and trader profit puts forth that traders who are able to buy information when others do not will be able to extract more value from their purchased clues. The capacity to anticipate others’ clue purchasing behavior requires understanding other people intentions.”

“Our finding regarding the negative effect of knowing others’ information purchasing decisions is of particular relevance…This result suggests that the advent of new technologies of information may have had two countervailing effects. On the one hand, information may have become less costly thanks to greater competition between news and data providers. On the other hand, social networks and other web-based communication technologies may have made traders more aware of others’ information acquisition strategies thus reducing the appeal for information purchasing.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.