I am an avid fan of capitalism as well as a critic.
While I agree that markets are generally better at discounting the future than individuals, there are inherent flaws in the markets that are difficult, if not impossible, to overcome. I point out these weaknesses because, just like with any mental model and organizing principle, knowing the weaknesses is the first step in avoiding or discounting them.
Imperfect Discounting Mechanisms
Many capitalists believe the markets are sacrosanct and, in their blind devotion, prove why "pure" is the root of puritanical. They cite aphorisms like “the wisdom of the crowd” or the improved predictions that come from crowdsourcing. I accept, acknowledge, and even revere the truth in these observations. After all, markets derive prices by aggregating differing expectations of the future.
But even the agglomeration of crowd opinion cannot overcome an inconvenient fact: time. That is, time marches in only one direction — forward. Effects follow causes. To the degree that causes are repeated, probable effects can be charted.
But the future is capricious. That is why we turn to markets in the first place. Were the future predictable, there would be no reason to aggregate differing views of supply and demand for goods and establish market clearing prices. Only The Price Preeminent would exist — an omniscient price that represents the market clearing price not just for current supply and demand, but for all time.
For example, if we knew in the late 1800s what we now know about the effect of hydrocarbons on the environment, they would have been priced higher. Alternatively, what if we could peer into the future and see the complete trajectory of human existence? And suppose, in that perfectly transparent timeline, we could see that potable water would eventually become scarce enough to result in the end of people? Obviously the signal from this All-Knowing Market would be very different.
But people are not seers. Yes, markets adjust to new information to balance supply and demand, but given our inability to predict the future, many goods and services are currently mispriced — perhaps dangerously so.
There are plenty of examples of markets doing a poor job of discounting.
A number of Samsung’s infamous Galaxy Note 7 phones spontaneously burst into flames causing much mayhem. You could argue that this is not a failure of the markets. But it is. After all, there was a market for these phones. Samsung eagerly supplied them and buyers eagerly purchased them. Once the fire hazard became known and the replacements failed to rectify the problem, the market disappeared. This illustrates both the power of markets and their primary weakness. Yes, the phones are no longer for sale since the entire market for them vanished, but signatories to the market for the Galaxy Note 7, both supplier and demander, failed to see far enough into the future to prevent catastrophe.
Another example is the side effects of prescription drugs that are not fully appreciated until many years into the drugs' use. This despite the extreme level of scrutiny on the front-end of drug development.
Possible Remedies
- Perhaps new products could be evaluated by their closeness to the natural world. For example, timber directly effects nature, consulting not so much. A proximity-to-nature continuum could also serve as a resiliency-monitoring tool. The closer to nature, the greater the need for systems thinking, scenario planning, and caution. This is not an argument for stifling regulation or for you to run out and hug a tree. I am saying that even when armed with market-cleared prices, people can screw things up. This means that any new product directly affecting the environment ought to be overpriced initially. This margin of safety could be put into a profit escrow account, assuming that the market still clears at the new price.
- Alternatively, as products are designed, they should have a built-in plan for the lifecycle of their components as well as contingency programs for how any potentially deleterious effects may be unwound. That is, what is the estate planning for a new product? How do you “put it to bed?”
- Perhaps a new product checklist should be developed, all the components of which must be addressed before a license to market is granted. A variation of the US Bureau of Consumer Protection could be the adjudicating body.
This article is the first in the five-part Where Markets Fail series. Subsequent entries will consider how markets:
- assume a context;
- assume fungibility;
- are not systemic; and,
- have "visible hands."
If you liked this post, don't forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.
Image credit: ©Getty Images/erhui1979
25 Comments
Hi Jason,
I think the basic disagreement is this: you believe that the price set in the market for certain goods is not correct, and you believe you know the direction in which it's incorrect (for example, the market price of fossil fuels is less than it should be), and you ascribe the difference between the market price and your judgment regarding the "correct" price to a failure of the market; the alternative, of course, is that it's your judgment that's incorrect.
To be clear, I've literally never met (or heard of) any human being who believes that any market is “all-knowing” or a “perfect discounting mechanism,” or that markets “cannot be criticized” or “are above reproach,” or even that any market is perfectly “free” or “efficient.” Still, the most important question is whether any superior mechanism exists, not in theory but in the real world given that human beings are fallible, exhibit cognitive biases and other behavioral imperfections, and may even be stupid.
As with democracy (see Churchill) the answer very clearly appears to be “no.” Various ways have been proposed to supplant (“improve”) markets, just as various ways have been proposed to supplant (“improve”) democracy: what they all seem to have in common is substituting one person’s judgment for the very definitely fallible collective judgment of others. And I’m not talking about central planning as the only alternative: even the smallest “nudge,” intended to move the market price back toward somebody’s idea of the “correct” price, will be done by somebody who is no less fallible than any of the other participants in the market, and no less subject to cognitive biases—and who was given the power to adjust the markets through a different collective decision-making process that was subject to its own problems (for example, democracy). That’s the problem: not that markets aren’t imperfect, but that there’s no way that is actually likely, in the real world, to improve on them.
To address the active/passive debate as an analogue, there has long been empirical evidence that many active managers are, in fact, able to outperform the market on a gross-of-fees basis. Again, I’ve literally never met anybody who thinks that it’s impossible to beat the market. Where active management fails—if it fails—is that clients can EXPECT to underperform the market on a NET-of-fees basis. Translation: the market price is not perfect—but there has never been evidence that it can be beaten without giving up something of even greater value.
--Brad
Hi Brad,
Thank you for your carefully considered and extended comments.
I actually don't think that I know better than markets all of the time. But I do think that it is possible to have expert opinion, and that some people do have more knowledge than others. Some people ARE more educated about future outcomes. Again, within investing, every active manager ought to believe this. I also think that with the growing sophistication of science, that we can be circumspect about many things that we previously could not be. And here is the real disagreement. I also think from a purely mercenary investment point of view, if you talk with a management team of a business and you believe they are delusional about their prospects, then you can short their securities. I can think of multiple contexts in which recognizing that markets are imperfect discounting mechanisms has a means of either increasing return, or avoiding loss.
Yours, in service,
Jason
Well, I certainly don't disagree with that--but all you're saying is that the market is a mechanism for encouraging anybody with superior information to reveal that information to other market participants by engaging in transactions, thereby moving the market price more closely toward the true value of whichever good is traded in that market.
In other words, that's not an example of an imperfect market, but of a perfect one.
Hello Brad and Ashok,
I truly appreciate the level of engagement you both have for this topic. We are going to have to agree to disagree. I think that markets do fail, and frequently, in terms of discounting. I think this is a hole that should be explored and thoughtfully, especially when effects can be irreversible. You both believe that I misunderstand markets and their functioning, and that my criticisms are unwarranted.
I am certain that regardless of what I write in this comments space, or what you write, that we will not approach agreement. I hope to engage you as thoroughly with the next four posts, too : )
Again, thanks,
Jason
Hello Jason..
Firstly, I want to address the Active-Passive debate. This is not one of my favourite debating points and I only said that the Active-Passive debate doesn't marshal much evidence for or against unbridled free market capitalism. Reason being, look, this is not a physical science that one controls for all the assumptions and looks at the effects of one changing factor on the output and see it 'happen' in a laboratory. Your conclusion, either way, I think rests on some studies which rely on tenuous assumptions.
I will weigh in briefly on the active-passive topic. Before reaching a conclusion, I think the active-passive research should ideally control for
a) Market maturity
b) Fund manager age and experience
c) Across different time periods
d) Consider a long time interval
In the Indian mutual fund experience, 90+% of the assets under management handsomely beat the benchmark. Even taking fees into account the alpha is significant. So does the Indian experience apply universally? In contrast, should the US experience apply universally?
As fund managers age and gain experience their ability to beat the market increases. Do any of the current research studies control for age and experience factor? How does one control these factors? Is the age of the managers alive now enough to draw conclusions?
Do any of the studies consider data from the 80s, 90s and 00s? So if Peter Lynch could beat the market during his time, does 'active management' apply today? I mean, if active management is proven once, does it need proof every year?
If active management fails today, does it mean there are no managers of Peter Lynch mettle currently? Or is it that managers of PL mettle exist, however, markets have got lawfully difficult to beat unlike before.
I have seen many of the research that try to settle the active-passive debate, focus on short time intervals, say post-2008. Why not a longer period? Is there a standard time interval in the first place?
There are no perfect answers to these questions. Which is why either way I think pulling this subject into the wider debate of market pricing or 'discounting' adds more confusion to what is being discussed already.
Back to the market pricing/discounting..
See, one of the fundamental problems with planners or anything top-down is that firstly such people are far removed from actual market dealings. If not now, they eventually become. Like, you used the phrase 'suppliers versus demanders' at a certain price. Traditionally, economists carry a certain disdain for consumers who they think act without brains, ethics and philosophies.
One of the failures of classical economists was trying to concentrate their efforts on Producers and Government whom they respected and presumed their research could find a buy. Whereas consumers where a scattered mass with no hearts. While you say I am absolutist, on the contrary, I am saying, consumers too have non-materialistic considerations. They are not an automatic order-matching cold-hearted object grabbers. The price-signal is tested against basic needs, ethical, philosophical and religious considerations. The 'subjective valuation' as traditionally defined is a bad economic theory. Buy Low Sell High, works in stock markets and it applies to businesses. But it fails to apply to consumers.
I am stressing on the need to understand human action because your proposition appears to be top-down and is far from reality. And the language certainly appears severely from the Top. Which is why it prompted the USSR examples (like the price of milk per gallon was decided by bureaucrats a few hundred miles away).
I am willing to wait and read the full series to comprehend your views properly.
Thanks for reading and responding to all comments.