Jeff Pfeffer on Why "Efficient Market" Thinking is Inefficient

Jeff Pfeffer has, for years now, been remarkably articulate about why some economic theories are often wrong and believing them can be hazardous to organizational health (full disclosure: I am biased as I have written some of these papers with him, but he worked in this area long before I started writing with him and he continues to do so).  Jeff has an especially lovely gem over at BNET that reflects his sense of humor, smarts, and persistent penchant to rely on evidence rather than to accept strong assumptions that cloud judgment on the trouble with "efficient market" thinking.

A taste:

You know the joke about two economists walking down the street and seeing a $20 bill lying on the sidewalk. The first economist says, “Look at that $20 bill.” The second says, “That can’t really be a $20 bill lying there, because if it were, someone would have picked it up already.” So they walk on, leaving the $20 bill undisturbed.

The logic — that there are no opportunities for achieving exceptional returns because if such opportunities existed, they would be quickly discovered and implemented by almost everyone — underlies not only the efficient market theory in the world of finance but is incredibly pervasive in management decisions about all sorts of topics. I have had people tell me that downsizing must be effective — notwithstanding lots of empirical evidence to the contrary — because if it weren’t, companies wouldn’t be doing it. Similarly for individual pay-for-performance incentive schemes and those pervasive, but despised, forced-curve performance evaluations that neither managers nor employees like but companies mandate. Most companies are doing them, so they must be a good thing to do, again, evidence to the contrary. Efficient market thinking presumes that not only are crowds wise — if everyone is doing something it must be optimal — but that, by inference, doing what everyone else does is the path to success or at least to avoiding calamity.

We should know better. In fact, we do: Numerous behavioral scientists ranging from Duke University social psychologist Dan Ariely to University of Chicago economist Richard Thaler, have shown that cognitive biases and irrational behavior are pervasive, crowds can be foolish as well as wise, and neither asset prices nor management practices necessarily make sense.

Jeff's arguments (read the rest, it gets even better) for some reason reminds of what one of my friends in college used to say when people were following the herd rather than thinking for themselves or taking a different path: "Eat shit, 10 billion flies can't be wrong."

Comments

[John]

Rules like these are fine... and Useful. Just like "The Theory of Evolution" doesn't guarantee the survival of EVERY species.... It does predict what has to happen for MOST species to survive!

In my mind... "Free Market Hypothesis" is similar... that on Average... Over long periods of time... it probably isn't worth chasing every arbitrage situation... because the people who really make the most on the Arbitrage are usually:
1. The guy holding the cards in the beginning
and
2. The brokers!

Eventually someone else will notice the Arbitrage situation and try to get in on the Action... and Ruin the whole thing! which is exactly what happened in the recent Real Estate Boom and Bust!

The "Instantaneous" part is just to simplify the math... and usually accompanies statements like "And it is left to the Student to prove how returns would accrue if the Arbitrage situation lasted 1-year at some level of decrement"

Thanks

[Doug Park]

Professor Pfeffer neatly summarizes how efficient market theory applies to understanding management practice: "Efficient market thinking presumes that not only are crowds wise — if everyone is doing something it must be optimal — but that, by inference, doing what everyone else does is the path to success or at least to avoiding calamity."

This explains why there is no much mindless copying of management practices that have no empirical support. It's the blind leading the blind, but everyone believes that they see clearly.

Read the entire piece, and as Bob says, it gets even better.

Full Disclosure: Jeff was a reader of a corporate governance specialty exam during my PhD program.

[Erik]

I have to say that this post has me scratching my head. Mr. Pfeffer seems to write about people who have a sound-bite understanding of the efficient market hypothesis and attempt to "use" it to justify management practices. Unfortunately, the article also reveals that Pfeffer's (and presumably your) understanding of the EMH and its implications (crowds are wise?) is hardly more advanced. My confidence in this blog just took two steps back with this posting.

[Lindsay from BNET]

Here's the link to the full Pfeffer piece on BNET: http://blogs.bnet.com/ceo/?p=2466

[Michael F. Martin]

The problem with EMH is with its interpretation of the principle of revealed preferences. Unfortunately, the same problematic interpretation often applies to behavioral critiques of EMH.

There are two catches to using preferences "revealed" by market prices to measure individual preferences. The first catch is that one has to watch over a period of time to see the preferences revealed, which means assuming that the preferences do not change during the period of observation. The second catch is that in practice, no large data sets have recorded the revealed preferences of individuals. Only aggregate data, such as consumer price indexes and average household spending over several decades, has been available. Taken together, these catches mean that empirical tests of the rational hypothesis take as a given that preferences do not change in time and that only information about the average preferences of a group is necessary to measure and predict individual preferences.

But preferences do change over time. New books are written, new paintings are painted, new inventions are conceived and reduced to practice. Moreover, no actual person may exist who embodies the average preferences of a large group. Especially if there are outliers, the average preferences of the group may be quite different from the preferences of most individuals within the group.

Unfortunately, many advocates of “behavioral economics” and “bounded rationality” seem to have made the same mistake as the EMH by interpreting the rational hypothesis as a hypothesis about individual behavior. Although it is true that individual behavior often deviates predictably from what might (mistakenly) be called “rational” given certain individual preferences, observations of individual psychology cannot usually provide a proper test of the rational hypothesis. In practice, it has been difficult to verify clear violations of the rational hypothesis. There is often an argument over whether what might be called irrational behavior results instead from rational preferences specific to a particular time and place. For example, although it might seem irrational for a group to demand higher payment for a good already owned than the same group would be willing to pay for the same good not owned, this asymmetry might be explained as rational in view of the consumer surplus in ownership for the group. Because the mechanism traditional economic theory uses to measure preferences is the observation of group behavior, arguments about whether the behavior of a particular group is rational or irrational can quickly devolve into circularity.

This is not to say, of course, that psychology offers no insight to economics. In fact it seems quite likely now that evolutionary psychology and neurology will offer insights into the origins and explanation of observed group behavior. Such insights are not as relevant, however, to the problem of measuring and managing large groups over long periods of time. Systems theory takes a different approach to rehabilitating economic theory.

[Joe Johnson]

Bob, I should learn not to drink coffee while reading your blog. Your friend's line is one of my old professor's favorite lines. If only all teachers in business school were required to teach that, we wouldn't have half the problems we have today.

[Randy]

Link?