Limits to arbitrage
Smart money can't always correct mispricing, so it persists.
What it means
The set of real-world frictions that prevent rational arbitrageurs from quickly eliminating mispricing, the key reason behavioral anomalies survive in markets. Even when prices stray from fundamentals, arbitrage is risky and costly: there may be no perfect substitute to hedge with (fundamental risk), the gap may widen before it closes (noise-trader risk), and short-selling, borrowing, and capital constraints limit how aggressively professionals can act. Crucially, arbitrageurs managing others' money face withdrawals after interim losses, so they cannot wait out mispricing indefinitely. It matters because it reconciles individual irrationality with the survival of anomalies: efficient-market forces are real but bounded.
Examples
Two near-identical securities trade at different prices for years because exploiting the gap requires capital and risk tolerance arbitrageurs lack.
In 2000, 3Com's stake in Palm was worth more than all of 3Com — a plain mispricing that survived because Palm shares were nearly impossible to borrow and short.
A fund manager who shorts an obvious bubble and watches it inflate another year loses her clients before she is proved right: being early is indistinguishable from being wrong.
First described in Shleifer & Vishny (1997); De Long et al. (1990).