What the "Efficient Market Theory" Has to Do With Where Your Firm Should Be in Five Years

Occasionally an article lies so irresistibly at the core intersection of economic theory and the professional interests of the "Adam Smith, Esq." community that,  despite the fact we are not here for a graduate seminar in economics, it simply demands to be featured.

Yesterday the WSJ had precisely such a column on its Op-Ed page under the byline of Henry G. Manne, dean emeritus of the George Mason University School of Law.

It's about behavioral finance and, at least as a "hook" for reeling in the WSJ readership, the argument for legalizing insider trading, expressed thusly at the conclusion of the piece (although that's really not what it's all about:

"We should rethink any current policies based on a view of pricing in which we exclude the best-informed traders and discard the wisdom of the many. For instance, we now have a new and more powerful argument than we had in the past for legalizing most insider or informed trading."

So I've told you what I think the piece is not about; what do I think it is about?

Primarily, the difference in economic analysis between Aggregate and Marginal behavior, and also, which is clearly more germane to readers of "Adam Smith, Esq.," the value of predictive markets.

Aggregate vs. Marginal behavior first. 

Mannes poses the fascinating question why, if "close approximation of the efficient market theory is still the most accurate and useful model of the stock market that we have," it's nonetheless the case that "the market-model claim of rationality often does not comport with actual human behavior."  How, in other words, to square the many many vindications of efficient market theory (the celebrated inability of mutual fund managers to beat the relevant averages over time, for example) with that theory's core assumption that investors behave rationally, when we know by simple cocktail party conversation that such an assumption is laughable?

Attempting to answer this (which, in your author's humble opinion, he doesn't finish doing—but there's a promised second part to the series), Mannes points to this as "containing the start of an answer":

"[I]n F.A. Hayek's classic "The Use of Knowledge in Society" (1945), Hayek (addressing the then-pressing problem of countering socialist doctrine) made the astute observation that centralized or socialist planning can never be economically efficient because it was impossible for a central planner to accumulate all the information needed for correct economic decisions ("correct" in the sense of displaying efficient market allocations of goods). The critical information, he noted, is too scattered in bits and pieces throughout the population ever to be assembled in one person's mind (or computer). Diffused markets, on the other hand, function well because the totality of relevant information, even subjective preferences, can be aggregated through the price mechanism into a correct market valuation.

"This insight of Hayek's has been a mainstay of market theory ever since it was advanced, but it remains merely an observation and a conclusion. It does not detail how new information gets so effectively impacted into the prices of goods and services. In other words, how does this "weighted averaging" get done? And why should we assume that the impact of rational participants would dominate that of irrational ones in markets?"

Mannes' answer is, essentially, to cite the thesis of James Surowiecki's "The Wisdom of Crowds," and its near-cousin, the value of prediction markets.

Why is this germane? 

Because (emphasis supplied):

"The literature on prediction markets makes clear that the more participants in a contest and the better informed they are, the more likely is the weighted average of their guesses to be the correct one. That is true, ironically, even though the additional participants have even less knowledge than the earlier ones. The only requirements for these markets to work well are that the various traders be diverse and that their judgments be independent of one another."

Back to "Adam Smith, Esq.:"  Why would your firm not create internal (or even external—what a concept!) prediction markets in areas such as which practice areas are expected to grow or to contract, where the firm should expand or dial back geographically, and which client industries/groups will be healthier or weaker in five years?

I would love it if you would hire me to make those predictions for you, and I certainly would enjoy walking through the thought process with your firm—but I am humbled by the new learning in economics, Mannes' article included, which instructs us that asking your partners, associates, staff, and even clients, what they "predict" is going to happen may be the most telling exercise of all.

Are you ready?

Posted by Bruce at June 14, 2006 7:37 AM | TrackBack
Posted to Finance | Globalization | Leadership | M&A | Partnership Structures | Practice Group Management | Strategy

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