The myths around efficient markets are really fascinating. On the one hand, it's been common wisdom for decades that markets are supposed to be efficient, ie, that you cannot systematically make money out of financial markets. On the other hand, there are a lot of paradoxes and inconsistencies around this belief. But what really worries me is that efficient market thinking is one of the big obstacles to long-term value creation. It makes people simply accept market outcomes without realizing that we, society, decide what the goal should be. Therefore, I would very much welcome a change in mindsets and methods towards adaptive markets thinking. So why is efficient market thinking an obstacle? Well, over time, this kind of thinking has become so pervasive that institutional investing has become mostly a numbers game of want, passive, factors, etc. Most people have forgotten that the investing is really about achieving goals in the real world in the future. Instead, they are just looking at that backward-looking quantum dashboard. This begs two questions. First, how has this happened? Second, aren't markets efficient then? Let me start with the second question, are markets efficient or not? The answer is a typical economist's answer. It all depends. It depends on factors like a number of market participants and their knowledge of relevant issues. This is the core of the adaptive markets thinking. Markets get more efficient as market participants get more information and learn how to interpret it. A famous example of strong market efficiency concerns the crash of the Space Shuttle Challenger in 1986. Within just a few days after the crash, the market was able to identify the NASA supplier most likely to be the cause of the event. That's credible in deed. However, in many cases, markets are not very efficient. For example, it has been well-documented that markets with low liquidity, markets in developing countries, and markets for small companies are much less efficient. In fact, it has been shown as carbon prices are hardly priced at all. The less information available and the less familiar market participants are with the issues, the less efficient markets will be. So there are serious limitations to market efficiency, and adaptive markets thinking explicitly takes those limitations into account. But let's go back to question 1. How did the efficient market thinking become so pervasive? Well, first of all, computing power became widely available. Investors and researchers could investigate the determinants of stock prices using the available data, namely historical patterns in stock prices, and they tried predicting stock prices in that way. That work mostly confirms that markets were efficient most of the time and that active management, ie stock picking, did not bring strong performance. This gave rise to passive firms, firms that offered whole indices and minimal cost and minimal career risk for those selecting the funds. In fund selection, funds were reduced to just a few metrics that measured historical financial returns collected risk as measured by historical volatility. This is problematic in at least two ways. First, if everyone does that, what will actually make market efficient? You need active managers for that. Second, it leaves no room for risk and return measures that are forward looking and non-financial. In my previous role as a firm manager, I continuously ran into this problem. Our impact fund had an explicit non-financial goal, but no one mentioned it except us. While financial performance was very strong, we got criticized for being high risk. The reason was simple, as we did not own fossil fuels, tobacco, airlines, etc, our portfolio deviated a lot from a civical index. So optically, our risk was high, but we would argue that this was low as we actually had positive exposure to externalities like government and sugar prices. But the clients didn't care because it did not fit their frameworks. That's frustrating, but what can we do about it? In a nutshell, we need to get a depth of markets thinking into our organizations and markets, that requires leadership from the top in setting broader goals and incentives than the current short-term hist ones. It also requires initiative in goods from people in operating roles as they will have to challenge their own methods and to change doing things they have been doing for years or even decades. That's a serious change process. In the meantime, don't forget that markets may be efficient at achieving goals, but that society needs to set those goals in the first place.
