This post first appeared on Harvard Business Review's blog, and is posted in conjunction with the publication of the October 2014 issue of the magazine's feature article, "The Rise (and Likely Fall) of the Talent Economy," which can be read in full here.
It is generally accepted that efficiency represents the optimal, aspirational state for any market. Efficient markets, which feature many buyers and sellers and perfect information flowing between them, determine the "right price" and hence allocate society's resources optimally.
Those are indeed positive features. But every good thing is like a face caressed by the sun. The rays that light and warm the face automatically cast a dark shadow behind it. The shadow of an efficient market is increased price volatility -- quite the opposite of what we expect from efficient markets.
Think about how markets evolve. We'll take the market for corn as an example. Farmers used to grow corn, take it to the local market, and sell it to families who use it to bake and cook. Primitive markets like this have two classic features. First, buyers and sellers have to be near to each other so it is a narrow and shallow market, restricted to relatively few people. Second, the value in the exchange is determined by immediate use. The buyer plans to consume the corn relatively promptly, not hold it as an investment or resell it.
As markets such as these evolve and the density of buyers and sellers increases, another actor inevitably arrives: the market maker who facilitates trading between sellers and buyers. They are useful. They help sellers find buyers and vice versa. With their participation, the market in question becomes more efficient. Suppliers can better find the buyers who want their good or service most and buyers can find all the suppliers of the item that they want. These are all good things.
But there is an unintended consequence. Actors in the system typically start to speculate. A market grows for those who imagine what consumers might find the good to be worth in the future. In due course, that corn gets traded not in the local market but on the Chicago Board of Trade (CBOT). In the very earliest days, real users of commodities were important players at the CBOT. They made contracts with sellers using the CBOT and actually took delivery of the corn they bought.
But that all changed over time. In the modern era, only a minuscule proportion of CBOT trades are intended for delivery. The vast majority are trades made on expectations of future value, not current use. Buyers don't want to take delivery on the corn, soybeans, or pork bellies. They are simply trading based on their beliefs about the future value to hypothetical future users of the product in question.
In the natural evolution of markets, as markets become more efficient, they turn from being use-driven to expectations-driven -- like equities, real estate, or derivatives based on both.
For this reason, the unintended consequence of efficiency is price volatility. In a use-driven market, the value of a good or service rarely changes dramatically in a short period of time. The value of a peck of corn to a family who needs to eat won't change much from week to week -- because the use is immediate and human habits don't change quickly. Indeed, if the weather in the growing season starts to deteriorate, then prices will migrate higher over the growing season as buyers and sellers both see that supply will be tight following the poor growing season.
To be sure, dramatic events can cause use to swing very quickly. When a hurricane approaches the Florida coast, the price of plywood can spike because everybody suddenly knows they need to board up their windows. After the hurricane, prices drop back to normal. But this is the exception, not the rule, in use-dominated markets.
Efficient, expectations-driven markets shift quickly for two reasons. First, expectations, unlike uses, have no bounds. They are the product of human imagination, which is ruled alternatively by fear and euphoria. There is simply no limit to how far and how fast expectations can shift. Every bubble and crash reinforces this. Dot-com companies weren't worth anything close to what their expectations suggested in 1999-2000, nor probably as little as their adjusted expectations implied after the bust. The same held for packages of securitized mortgages in the summer of 2008 and for Dow Jones 30 stocks in March 2009.
Second, expectations extend deep into the imagined future. Rising rents for a piece of real estate may be expected to rise forever. Profit growth of a company may be expected to continue ad infinitum, or losses until bankruptcy. Thus when expectations change, the change is implicitly projected far into the future and discounted back to the present, resulting in a much amplified change in value. One bad quarter can trigger a run on your stock and one good quarter can prompt a feeding frenzy.
So efficiency doesn't inherently produce smoothness and stability in prices; it produces spikiness, the dark side of efficiency and expectations.
That dark side has not gone unnoticed. It has spurred the growth of an entire industry that exists only to exploit volatility: the hedge fund business. Thanks to the fact that their compensation is dominated by their carried-interest (the 20% in the famous 2&20 formula), their returns are driven by volatility -- the more the better. And if more is better, why simply wait for volatility to happen? Why not band together to purposely exacerbate and profit from volatility?
Meanwhile, there are all sorts of good folks operating in use-driven markets, producing goods and services that we use on a daily basis. Most are organized as public companies with stock prices that are jerked around by the volatility aficionados. So while they are working on something that we all want -- more and better products and services -- they have to deal with the a huge group of influential wielders of capital who exist only to exploit whatever level of volatility they can create.
This is the dark side of efficient markets: systematically high volatility and an entire industry that exists to exploit and exacerbate it.
To read "The Rise (and Likely Fall) of the Talent Economy," click here.