Investments, tenth edition

  Limits to Arbitrage 

 Behavioral biases would not matter for stock pricing if rational arbitrageurs could fully 

exploit the mistakes of behavioral investors. Trades of profit-seeking investors would cor-

rect any misalignment of prices. However, behavioral advocates argue that in practice, 

several factors limit the ability to profit from mispricing.  

14

   

  Fundamental Risk   

Suppose that a share of IBM is underpriced. Buying it may pre-

sent a profit opportunity, but it is hardly risk-free, because the presumed market under-

pricing can get worse. While price eventually should converge to intrinsic value, this may 

not happen until after the trader’s investment horizon. For example, the investor may be 

a mutual fund manager who may lose clients (not to mention a job!) if short-term per-

formance is poor, or a trader who may run through her capital if the market turns against 

her, even temporarily. A comment often attributed to the famous economist John Maynard 

Keynes is that “markets can remain irrational longer than you can remain solvent.” The 

   fundamental  risk    incurred in exploiting apparent profit opportunities presumably will 

limit the activity of traders.    

  

13

 J. D. Coval and T. Shumway, “Do Behavioral Biases Affect Prices?”  Journal of Finance  60 (February 2005), 

pp. 1–34. 

  

14

 Some of the more influential references on limits to arbitrage are J. B. DeLong, A. Schleifer, L. Summers, 

and R. Waldmann, “Noise Trader Risk in Financial Markets,”  Journal of Political Economy  98 (August 1990), 

pp. 704–38; and A. Schleifer and R. Vishny, “The Limits of Arbitrage,”  Journal of Finance  52 (March 1997), 

pp. 35–55. 

 In mid-2012, the NASDAQ index fluctuated at a level around 2,900. From that perspec-

tive, the value the index had reached in 2000, around 5,000, seemed obviously crazy. 

Surely some investors living through the Internet “bubble” of the late 1990s must have 

identified the index as grossly overvalued, suggesting a good selling opportunity. But 

this hardly would have been a riskless arbitrage opportunity. Consider that NASDAQ 

may also have been overvalued in 1999 when it first crossed above 3,500 (20% higher 

than its value in 2012). An investor in 1999 who believed (as it turns out, quite correctly) 

that NASDAQ was overvalued at 3,500 and decided to sell it short would have suffered 

enormous losses as the index increased by another 1,500 points before finally peaking 

at 5,000. While the investor might have derived considerable satisfaction at eventually 

being proven right about the overpricing, by entering a year before the market “cor-

rected,” he might also have gone broke. 

 Example  12.2 

Fundamental Risk 

bod61671_ch12_388-413.indd   394

bod61671_ch12_388-413.indd   394

7/17/13   3:46 PM

7/17/13   3:46 PM

Final PDF to printer

---

395