To-MAY-to, To-MAH-to.

There's a theory -  well a couple of theories, actually - about how emotional, irrational human beings are possibly able to run (mostly) logical and (frequently) rational markets.

First off, there's the Efficient Markets Hypothesis (the "EMH").  It boils down to the idea that "real marketeers" know how to play the game rationally and logically and they eventually get the right amount of money into the right hands.  Eventually.  They are occasionally outnumbered or outgunned by irrational morons that co-opt the market's function and cause it to malfunction.  However, over The Long Run, these idiots will get cleaned out and the system will resume its normal function.  Stay out of the market's way, and everything will be fine.

("The Long Run" is Econo-mese for "wait long enough and you'll see this if you haven't died yet."  It's also a great Eagles song.)

Second off, there's the Inefficient Market Hypothesis (the "IMH").  Guess what it says?

Alright, I'll tell you.  Basically, all human beings can do stupid things sometimes.  Not even stupid, really - just misguided.  Or maybe influenced by extra-market forces like politics, fear, or ego.   In any event, the IMH tells "real marketeers," essentially (with apologies to Commodore Perry and Walter Kelly): "We have met the idiot, and sometimes he is you."   Markets are run by flawed humans.  Ergo, markets are flawed.  Let's all just deal with it by having some rules on how to play nice and all talking about what our needs and goals are.

You can probably sense a chicken/egg argument brewing here.  And it really is one.  Do markets fail because "real marketeers" can't always overcome the idiots that show up from time to time?  Or are the idiots always there?  Or are the idiots who think they are "real marketeers" really the problem? Or are the "real marketeers" not always willing to clean out the idiots, for idiotic reasons of their own?  Markets work well enough most of the time to lend strong support for the EMH.  But when they collapse, that IMH looks pretty appealing.

One of the ways the EMH goes about finding the idiots is, reasonably enough, pointing out the idiot behaviors that "real marketeers" don't fall for.  One of the most common is the over-reliance on an "anchoring heuristic."  This concept is important enough that I will dispense with my usual snarky parenthetical and actually explain it.

An anchoring heuristic is a decision-making shortcut.  I can't decide which school is better for my kid, so I choose the one with the lowest student/teacher ratio.  I can't decide whether to get the brand name or the generic, so I choose the one with the lowest cost per weight.  I can't decide which stock to buy, so I choose the one with the lowest price to earnings ratio.  Each decision is based on a number; and that number is derived from two other numbers which represent values that I BELIEVE are related to the outcome I want.  

I believe that one adult can only handle a limited number of children effectively - no matter what the education or experience level of that adult.  I believe that I will be better off spending the least amount of money possible per unit at the grocery store - because I do not believe that there is a significant difference in quality between the generic and the brand name.  I believe that a company that makes the same amount of money but posts a lower stock price than a competitor is a better investment - regardless of the rest of its balance sheet.  I make a conscious decision to forego thinking about some potentially critical information based on my beliefs and my time.

An anchoring heuristic is useful in making a decision which could otherwise be very time-consuming.  In fact, without them, any value you might receive from making the "really right" decision might be eaten up by the cost of the time it took to make the decision.  Sometimes, the logical, rational, unemotional decision is to just decide what to do based on limited information and what you believe is true.  Perfectly reasonable.  Happens every day.  Markets have functioned around the world under these conditions for hundreds if not thousands of years.

What would be irrational is to postpone a decision and continue to study the issue and come up with a "really right" answer that might be worthless - because you wasted so much effort coming to the decision that you could no longer profit from it.  Markets seize up and die because no one "pulls the trigger."  Or worse, they are never born.

So guess what happened when an entire market with a notional value of trillions of dollars is based on ONE anchoring heuristic?  And when that anchoring heuristic is based on two other anchoring heuristics?  

A heckuva efficient market - that's what!  We've got rationality coming out of our ears, here!  Everyone agrees on the valuation model, the rules for how to apply the model, the data that goes into the model - the thing ran like a Swiss watch.  There was no room for fear and ego, folks.  If the numbers worked, the numbers worked.

Unfortunately, the "real marketeers" forgot the one thing that makes an anchoring heuristic valuable: deliberate ignorance of some potentially crucial factors based on a belief that they are irrelevant or unlikely.  Without this anchoring heuristic, the analysis involved would have been so cumbersome that the market would never have existed.  On the other hand, the logical, rational decision to overlook those factors invited a tidal wave of market participants who had no idea what they were buying and selling.  Worse, they had no idea that the anchoring heuristic that guided them was fundamentally, fatally flawed.  Idiots.

At this point, the IMH crowd starts chanting "nanny-nanny-boo-boo" to the EMH crowd.  They fell victim to one of the classic blunders: this market was based entirely on behavior the EMH defines as irrational!  Ergo, this market was fundamentally inefficient and doomed to fail in the absence of rules and oversight!  

Well, I have a couple of questions for Mr. IMH.  How could a market based completely on a made-up formula be made better by made-up rules?  Also, correct me if I'm wrong, the market DID run - largely without official rules or disclosures - for the better part of a decade, yes?

I'll go ahead and answer: it can't and it did.  Rational actors independently and unanimously agreed on a standard and built a multi-trillion dollar market on nothing more than a shared idea.  I find this remarkable.  It just so happened that the basic assumptions of the market were flawed.  But then,  humans spent the better part of history thinking the sun revolved around the earth.  We still call the planets by their Roman names and the constellations are from Greek mythology.

Chicken, meet egg.  The securitized asset market of the early 21st century was started by a flawed human being (IMH) who wrote a logical formula (EMH) based on incomplete historical data (IMH) applied by calculating financiers (EMH) who reported to uncomprehending management (IMH) watched by bean-counting investors (EMH) under lax regulations written by clueless bureaucrats (IMH) tasked with monitoring what was once the broadest, deepest and most free market in human history (EMH).  

Before the anchoring heuristic, this market was narrow and relatively shallow.  With the anchoring heuristic, the market took off, flew, crashed and burned.    Now that the anchoring heuristic no longer appears reliable, that market will not return.  So what does this tell us about the fundamental rationality of markets?  Was it rational to risk so much on an equation?  Or would we have been crazy to pass up the chance that it just might work?  Most importantly, will we remember the lesson?  Whatever lesson that is...