REVISITING MARKET EFFICIENCY: THE STOCK MARKET AS A COMPLEX ADAPTIVE SYSTEM

by Michael J. Mauboussin, Credit Suisse First Boston

t is time to shift the emphasis of the debate about market efficiency. Most academics and practitioners agree that markets are efficient by a reasonable operational criterion: there is no systematic way to exploit opportunities for superior gains. But we need to reorient the discussion to how this operational efficiency arises. The crux of the debate boils down to whether we should consider investors to be rational, well informed, and homogeneous—the backbone of standard capital markets theory—or potentially irrational, operating with incomplete information, and relying on varying decision rules. The latter characteristics are part and parcel of a relatively newly articulated phenomenon that researchers at the Santa Fe Institute and elsewhere call complex adaptive systems. Why should corporate managers care about how market efficiency arises? In truth, executives can make many corporate finance decisions independent of the means of market efficiency. But if complex adaptive systems do a better job explaining how markets work, there are critical implications for areas such as risk management and investor communications.

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Take, for example, the earnings expectations game.1 In a complex adaptive system, the sum is greater than the parts. So it is not possible to understand the stock market by paying attention to individual analysts. Managers who place a disproportionate focus on the perceived desires of these analysts may be managing to the wrong metrics— and ultimately destroying shareholder value. A better appreciation for how markets work will shift management attention away from individual analysts to the market itself, thus capturing the aggregation of many diverse views. Standard capital markets theory still has a lot to