'Efficient Market' Thinking Is Inefficient

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. Look no further than the recent financial debacle. Justin Fox has recently written The Myth of the Rational Market, a book describing the history and people behind the efficient markets hypothesis in finance and how that theory managed to survive lots of contrary evidence for a long time. Fox's book reflects my experience that belief often trumps evidence.

There is an obvious paradox for companies and managers who fall into the Panglossian view that every pervasive practice must be for the best because information markets are efficient. The paradox is that you can't achieve extraordinary success by copying what everyone else is doing. If you do, you get pretty much the same results as everyone else. That's why Malcolm Gladwell has written about the strategic advantage, particularly for underdogs, of not playing by the conventional rules in sports, war, or business.

In virtually every area of business, the companies that have broken from the pack have not only seen some common sense business truths but have been willing to act on that insight, even when others weren't. Southwest Airlines long ago understood that people paid to get from one place to the other, so that a hub and spoke system that routed people through busy airports with lots of delays not only irritated the passengers but was economically harmful to the airline, which was not making money while people made connections, taxied, and waited to take off. Whole Foods Market understood that people would pay more for food they wanted to eat, which led not only to a focus on organics but also to permitting local stores to alter their food selections to appeal to local tastes. This decentralization of stocking decisions violated the conventional wisdom in the grocery business that it's all about costs, which go up if you don't purchase in large quantities. Recently, retailer Macy's seems to have figured out the same thing for its stores, and is finally going to permit variations in merchandise assortments to reflect local buying patterns.

The problem with belief in efficient markets is that it leads managers to stop trying to outcompete their rivals because there's no point. The idea also leads to lots of benchmarking and following the crowd. The problem with benchmarking is that it gets you to the middle of the pack, not to the top -- and also ignores differences in strategies and conditions facing different companies. If all you need to do is copy others because they have already discovered the "truths" about your business, what justifies enormous executive salaries? Why should following the crowd be that difficult or expensive?

So, if you have an idea that makes sense and goes against the "market," whatever that market is, go for it. Who knows, you might create the next Apple, another company that has eschewed "the market is always right" thinking in its product designs and in its decision to keep $25 billion on its balance sheet so it could keep innovating during a recession when its rivals were weak.