Markets as selection devices

One of the stronger defences of free markets is that they act as selection mechanisms. To the allegations that stock markets aren’t efficient because investors are irrational or that firms can’t maximize profits because bosses don’t know what they’re doing, the reply is that this might be so, but the market eliminates egregious irrationality and selects for those firms that have stumbled upon profitable strategies.

This, though poses the question: how does selection really work? A new paper by Pascal Seppecher and colleagues at the University of Paris gives one answer. They show that selection can lead to “wild fluctuations and deep downturns”. For example in good times, the market selects for companies who borrow to expand because these take market share from their cautious rivals. However, high leverage exposes firms to the risk of bankruptcy when an adverse shock occurs, which leads to a sharp downturn as they try to deleverage. You needn’t look far for an example of this; it describes banks behaviour in 00s.

The problem here is that, when faced with selection pressures, firms face a trade-off between what James March called (pdf) exploration versus exploitation. The firm that maximally exploits existing conditions will be maladapted when those conditions change. The firm that invests in exploring alternative strategies might survive change, but at the expense of not maximizing short-term profits.

To put this another way, the best chance of survival in a changing environment is to pursue mixed strategies. But these – by definition – do not maximize “shareholder value” in the short-run. And if all firms in an industry pursue the same strategy, we can have massive systemic instability, as the banking system showed us (pdf).

It’s not just change in the environment over time that can lead to maladaption, corporate death and downturns. A similar problem occurs when businessmen move from one environment to another. For example, the market in sportswear selected in favour of Mike Ashley’s ruthless cost-cutting. But that strategy when applied to Newcastle United proved less successful*. Or to take a more outlandish example, the market selects in favour of property developers who “restructure” their debts and dodge taxes. But it’s not so clear that such strategies are a good way of handling the government’s finances.

In fact, there’s another problem here: markets might select not for sensible behaviour but for lucky chancers. As Armen Alchian wrote in a brilliant paper (pdf) way back in 1950:

The greater the uncertainties of the world, the greater is the possibility that profits would go to venturesome and lucky rather than to logical, careful fact-gathering individuals.

This is surely true in financial markets. Bjorn-Christopher Witte has shown that risk-taking fund managers can attract more inflows and higher salaries than more cautious but better managers. Economists at Cass Business School corroborate this. They show that just six months of good performance (far too short a period to demonstrate skill rather than luck) can attract inflows into funds – and those funds go on to under-perform.

In a similar vein, Brock Mendel and Andrei Shleifer show that investor can chase (pdf) noise – a process which can give big profits to the irrational noise investor who bought over-priced assets early enough.

Now, in saying all this I don’t mean to reject the analogy between markets and natural selection. Quite the opposite. It’s a good one – especially but not only in financial markets. We should push it further, and ask: what exactly is it that the market selects for? How fierce is the selection process; the existence of a “long tail” of badly managed firms (pdf) suggests it isn’t always and swiftly brutal? And: how vulnerable are today’s survivors to the danger of a change in market conditions?

These answers will of course vary from market to market and time to time. But that’s the point. Economics is (or should be) an empirical discipline. Windy talk about “optimality” isn’t good enough. Sometimes, the invisible hand gets the tremors.

* Yes, Ashley did invest in the club last season, but that change came too late.

Comments

[Bob]

Always remember the stock market is a *secondary* market.

[odeboyz]

"Yes Ashley did invest in the club last season, but that change came too late."

Ashley didn't 'invest' last season he behaved like a punter in a bookies who has been losing all afternoon and puts all his money on the favourite in the last race.

[Leo]

One way of looking at attempts to regulate markets is as an attempt to change what a market selects for. In the long, protracted battle over the implementation of the Leveson report, which I had a ringside view of, that's how I came to see it: Leveson, Hacked Off and other supporters of regulation had a view of what 'good' journalism is and wanted to regulate the news market so that it selected for 'good' journalism and made hitherto dominant 'bad' kinds unprofitable. After all, the whole reason newspapers resorted to phone hacking in the first place was as a cheap way of getting great stories that would otherwise have cost an arm and a leg in experienced reporters with incredible contacts. Another way of putting it is, technological change brought into play a means of deskilling their workforce, laying off staff and still produce a 'better' product. Truly 'doing more with less'. And of course it wasn't just phone hacking - there were all the data protection offences looked at by Operation Motorman but never prosecuted. The use of illegal and unethical means was only possible because there seemed no meaningful threat of regulation: the Press Complaints Commission was toothless and totally captured by the industry, and the police were incredibly reluctant to investigate journalists, especially tabloid journalists who were their great friends and allies.

Of course, many publishers could see that Leveson's proposed regulatory system represented an existential threat to their business models, which had been assembled over decades in a market whose only regulation was laws of libel and contempt. There was basically no regulation of the production process, and, save the aforementioned laws, no regulation of the product's quality either. The prospect of new regulation to, in effect, dramatically raise quality standards was no doubt terrifying for them. For instance, consider what would happen if the Daily Mail were forced to run equally prominent corrections and apologies for every inaccurate story it published. Either the brand would quickly be trashed in the eyes of its readers or it would become boring to read. Similarly, if it had to go to arbitration and pay out to every person who had a legitimate claim against it for harassing them, invading their privacy or defaming them, it would be a much less profitable title. Leveson's plans involved making access to legal redress against newspapers more affordable for ordinary people, so Associated Newspapers lobbied hard against those plans being implemented. Just as it lobbied to make it more difficult for ordinary people to bring civil claims against it, for instance through trying to get rid of conditional fee agreements: http://www.theguardian.com/media/2009/feb/19/no-win-no-fee-lawyers-shackling-newspapers

One of the arguments the newspaper publishers made was that the internet had changed journalism so completely that it made regulation unnecessary. There was an important element of truth in that: by undermining the excludability of news, the internet has made news more of a public good and less able to be monetised (leaving aside the transformation of the advertising market). As a consequence, original news reporting is an even less profitable activity than it was before. Therefore, why bother going to the trouble and cost of paying someone to break the law to uncover a news story when there isn't even much money in it? So in that sense, yes, Leveson's analysis wasn't terribly forward-looking.

However, the new news market selects even more for all kinds of things which are a million miles away from the traditional 'All the President's Men' view of what journalism should be about: clickbait, stories plagiarised wholesale from rival sites, etc. It selects even less than the newspaper market did for brands that do news origination, have skilled and knowledgable reporters, or check facts. And perhaps most worryingly, the virtual impossibility of a digital business model for news that doesn't include native advertising is probably going to select to an even greater degree than in the past for editorial agendas which fit with the needs of advertisers (e.g. BuzzFeed deciding that it wouldn't do negative book reviews: http://www.thewire.com/entertainment/2013/11/buzzfeed-decides-criticizing-awful-books-too-mean/71366/).

One of the major weaknesses of the pro-press regulation side in the post-Leveson battle was its inability to offer publishers and especially journalists ways of making 'good' journalism more financially viable. There were some ways it would have lowered legal costs and given them better protection from financial intimidation by wealthy individuals, but they weren't enough. Even if they had come up with the holy grail, of course some publishers are at this point irredeemable and would have opposed all the same. It wasn't enough to design market regulation that would select for 'good' publishers that didn't do 'bad' journalism, because the bad publishers already existed, were powerful and would inevitably use their power to block changes to the environment they operated in. I suppose that's a general problem with trying to introduce regulation to correct long-running bad practices in all sorts of industries.

[Leo]

Sorry, that second link should be: http://www.thewire.com/entertainment/2013/11/buzzfeed-decides-criticizing-awful-books-too-mean/71366/

[The Barefoot Bum]

Another problem with markets as a selection mechanism is to specify what precisely is being selected. Biological selection selects genes by organisms' reproductive success, but what is the analog to firms? Organisms are to genes as firms are to ... well, what? And what about heritability?

I know just enough about evolutionary biology to know that I don't know jack about evolutionary biology, and because I don't really know what I'm talking about, it would be all too easy to say the most egregiously stupid things about it.

I have enough trouble trying to understand economics on its own terms; I don't want to try to apply sophisticated models I don't understand from fields in which I have zero education.

[chris]

@ The Barefoot Bum. That's a good q. I suspect that failure to appreciate this leads to overconfidence. People who have been successful think they've been selected for their brilliance, when in fact the selection operates upon a specific thing they did (maybe by luck). If so, they can subsequently make mistakes - eg investors who take on more risk, businessmen who enter different industries, and so on.

[UnlearningEcon]

I'm not trying to do a 'gotcha' here Chris, but doesn't a lot of the evidence you present here contradict your support for the EMH?

[Blissex]

«The best chance of survival in a changing environment is to pursue mixed strategies.»
«Another problem with markets as a selection mechanism is to specify what precisely is being selected»

A vital and often overlooked detail here is that "weak" companies get *taken over* by "strong" companies, and this usually happens among *competitors*, and a take-over usually involves the firing of the executives of the competitor taken over, and a boost in the "compensation" of the executives of the company taking over. Also, executives tenure is usually under 10 years.

It is as usual extremely misleading to write in terms of «when faced with selection pressures, firms face a trade-off between what James March called (pdf) exploration versus exploitation», because it is not «firms» but *executive* that «face a trade-off».

Therefore executives, who are in effect "the firm", try to select for *their own* survival.

This means that they try to avoid their company being taken over *during their own tenure*, so as to extract the maximum advantage from that tenure, as long as it lasts, and it also includes maximizing compensation which is proportional to volatility (beta), but only upwards.

Therefore they tend to have strong incentive to maximize the growth (book/paper) earnings during their tenure, regardless of what this does to the long term risks for the company, for example by the usual technique of under-depreciating some assets, effectively asset-stripping their companies (e.g. by underestimating risks).

So a mixed strategy, or even worse a prudent long-term strategy, are not in an executive's best interests, and they are rarely chosen by public companies effectively controlled by their executives.

Consider company A, where the executives choose a wildly pro-cyclical, asset stripping, strategy, and its competitors B where the executives choose a prudent anti-cyclical, asset growing, strategy in the two cases:

* During an up-phase of the cycle, A *apparent* (book/paper) performance will be vastly superior to that of B, and the executive team of A will be able to buy competitor B for peanuts (e.g. "all share deal") and fire their rivals, and then use company B's resources and absence from their shared market to ride out the subsequent down-phase.

* During a down phase of the cycle, company B will outperform company A, and take-overs are not done during a down-phase, and company B would anyhow be imprudent to buy company A which is geared for blowing up during down-phases. As long as company A does not actually go bankrupt (or even if it does) its executives are more likely to keep their positions of rent during a down-phase than the executives of company B during an up-phase.

The above is the long form of "But as long as the music is playing, you've got to get up and dance".

Notes:

* D Hendon pointed out that the stock market is a market for corporate control, not for investments.
* D Hendon pointed out that M Jensen made a widely (in anglo-american culture countries) implemented recommendation to make hostile take-overs easier, and this has as intended radically reduced the long term stake of executives in their companies.
* W Black continues to point out that executives "control frauds" continue to be a "sure thing".
* Several studies show that executive compensation is primarily dependent on company size rather than performance, and then on volatility, as executives get rewarded for increases in stock price relative to its own recent past, not relative to peers or the long term.

[Blissex]

«evidence you present here contradict your support for the EMH?»

There are *several* EMHs, and the weaker ones are pretty weak, and the usual definitions are more subtle (and weaker) than they look.

So I don't find much of a contradiction here.

[chris]

@ Unlearning - my view of the EMH has changed over time; I'm now more sceptical than a few years ago. I have two doubts:
1. The aggregate market can become over- or under-priced. It can, as Shiller & Samuelson said, be "macro inefficient".
2. It's not wholly micro efficient: the success of defensive and momentum stocks is evidence against the pure EMH.
However, for many practical purposes, the EMH is good enough. I would (and do) advise investors against buying most actively managed funds. The fact that most under-perform over the long-run suggests the EMH isn't wholly false.

[Keith]

Comparing Firms to evolving species is valid. But a vital point about that is of course that from a long run view, after the event, evolution is extremely wasteful.

Most species in biology are extinct.

Because the future is uncertain and evolution works without a conscious plan it produces fitness only slowly with great suffering and fitness is never enough for survival given the open ended nature of change. All species die off eventually when they encounter a environmental challenge they just cannot cope with. So relying on this as a way to improve the economy is dubious. The tendency for great empires to fall despite long periods of greatness shows the futility of trying to find a universal method of success. No one has found it yet in politics or economics.

[Blissex]

«the futility of trying to find a universal method of success. No one has found it yet in politics or economics»

I greatly sympathize with this, because one of the constant delusions of many is that there is a "right mechanism" in politics and political economy that if only were adopted systematically it would guarantee best outcomes.

It can be "capitalism", "non-coercive bargains", "MMT", "rule by philosopher-kings/whitehall mandarins/centrist technocrats", "enlightened one party rule", "democracy", "two-party systems", etc.

My impression is that best outcomes are overly ambitious and merely good outcomes to be prized, and they are reached by good judgement and luck, and there is no substitute for adaptive good judgement by the majority of the population. And eventually luck runs out.

PS I am particularly skeptical of any surefire recipe that involves any variant of "rule by philosopher-kings".

[UnlearningEcon]

I suppose the question is whether a theory(s) exist which can reconcile the observation that the market is hard to beat with the kind of regularities you identify.