Presidential Address: Sophisticated Investors and Market Efficiency



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    • Jeremy C. Stein is from Harvard University and NBER. Presidential Address delivered to the American Finance Association, San Francisco, January 4, 2009. I am indebted to Sam Hanson for outstanding research assistance. I also thank John Campbell, Harrison Hong, Robin Greenwood, Borja Larrain, Andrei Shleifer, Erik Stafford, Dimitri Vayanos, Ivo Welch, and seminar participants at Harvard for helpful comments and suggestions.


Stock-market trading is increasingly dominated by sophisticated professionals, as opposed to individual investors. Will this trend ultimately lead to greater market efficiency? I consider two complicating factors. The first is crowding—the fact that, for a wide range of “unanchored” strategies, an arbitrageur cannot know how many of his peers are simultaneously entering the same trade. The second is leverage—when an arbitrageur chooses a privately optimal leverage ratio, he may create a fire-sale externality that raises the likelihood of a severe crash. In some cases, capital regulation may be helpful in dealing with the latter problem.