It takes hard work to maintain prices at their fundamental values. Accurate, responsive and informative prices do not occur by magic. Analysts have to diligently monitor firms prospects and security prices. Market makers have to sustain a trustworthy and relatively liquid trading environment. Firms have to issue and honor publicly traded shares.
Markets with publicly posted prices1 are a form of institutional capital that needs to be operated and maintained just like any other form of capital. Given these properties, what is the optimal amount of this institutional capital to use in our production function?
2. Nickle and Dimed
A common mis-perception is that, as technology improves and the number of market participants increases, the costs of maintaining markets drops to a negligible level. For example, Eugene Fama and Ken French write on their blog2 that:
“If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.” — Eugene Fama and Ken French
However, even if it only takes each analyst a couple of seconds to look at his portfolio every day, due to the size of modern financial markets this effort will still add up to a meaningful total. Consider the example below that illustrates this point:
Example (Google’s Pac-Man Homage): Analysts at the software firm Rescue Time studied the browsing habits and Google usage of roughly users in May, 2010. The firm makes time tracking software that keeps an eye on what workers do and where they go online.
On a typical day, people in the sample conducted roughly searches on the Google page. Each one of these searches lasts about seconds. Putting Pac-Man on the Google homepage increased the average time spent on the page by an average of about seconds.3
Extrapolating this up across the million unique users who visit the main Google page day-to-day, this represents an increase of million hours – equal to about years! In dollar terms, assuming people are paid roughly , this equates to about in lost productivity.
3. The Brain Drain
There are a few papers like Abel, Eberly and Panageas (2007) which address this problem of optimal inattention, but I do not know of any papers which explicitly examine the welfare effects of too much or too little attention to asset markets.
To my knowledge, the closest paper to this line of analysis is Philippon (2007) which posits a simple general equilibrium model to digest the welfare effects of the recent growth in the output of US financial sector. The plot below shows that by 2006, the financial sector was generating roughly of US GDP. However, this study focuses on expenditures in the corporate finance side of the financial industry.
I am interested in a slightly different question. i.e., how much time should we worry about the markets? To see the importance of this trade off consider the example below. Lots of very smart physicists have left academic and industrial engineering positions to work on Wall Street over the course of the last years4:
Example (Physics Brain Drain): Suppose that all these skilled analysts were making market more efficient by pinning asset prices closer to their “correct” values. How much better off are we due to this marginal improvement in asset pricing accuracy? How much more productive would our world be if these people had foregone their finance careers and focused on the material physics behind computer hardware or the complex programming problems that underpin parallel computing?
4. Why Do Public Markets Persist?
In spite of their operating and maintenance costs, markets with publicly posted prices remain a common method of allocating physical goods, control rights and risk. For instance, the total value of U.S. equity markets exceeds the total U.S. GDP by a factor of at least as shown below5:
There must be some positive externality to having fairly accurate and publicly displayed asset prices, otherwise these types of exchanges wouldn’t be so popular.6 I think that this insight that accurate, public prices must confer a positive externality is the key to understanding how making asset prices more accurate will improve welfare.
- Alternative methods include procedures such as over-the-counter exchanges or dark pools. ↩
- This post relates to their 2007 paper: Disagreement, Tastes and Asset Prices. ↩
- These figures will form the basis of a back of the envelope calculation which may be biased either up or down. On one hand, the figure could over estimate the number of Google searches done per day as the software is voluntarily used by technically savvy employees. On the other hand, the estimates could be biased downward as only a minority of users realised that the logo was playable. To play, people had to click on the “insert coin” button which replaced the more familiar “I’m Feeling Lucky” button. ↩
- See Steve Hsu’s (2010) review of The Quants for Physics World. ↩
- Source: The Big Picture. ↩
- …even in prison! ↩