Smart people have come into finance. But contrary to what economic theory suggests, the increased IQ hasn’t stabilised markets. In fact, argues Professor Harrison Hong, it seems they have returned to the kind of instability associated with stock markets around 100 years ago.
‘If you really want to know why the financial system nearly collapsed in the fall of 2008, I can tell you in one sentence… because smart guys had started working on Wall Street.’
Calvin Trillin, ‘Wall Street Smarts’ New York Times, October 13, 2009
In the past 30 years, the people working in finance have become smarter and smarter. Like moths to a light bulb, the world’s best and brightest have been drawn to Wall Street by astronomical rewards. Three Nobel Prizes in less than 20 years awarded for advances in financial engineering for the capital markets; skyrocketing numbers of PhDs and Masters in finance globally; and technological advances in capital markets, which have greatly outstripped those in other industries, attest to the brain power that has made its way into this industry over others.
But contrary to what traditional economics – in the form of the efficient markets hypothesis – would suggest, smart thinking and smart practice have not brought market stability. In fact, the bubbles and troughs that we see today are as frequent and as destabilising as those that characterised the less mature and more fragmented markets at the beginning of the evolution of capital markets a century ago.
It turns out that the very cleverness that makes markets much more efficient than they used to be also affects their stability and robustness. Because market participants are smarter, they switch on to trends much faster – they pile in on the way up and bail out on the way down much faster than they used to. This affects volatility and makes markets much more prone to bubbles and busts.
The smartest guys in the room
Evidence that clever people have been attracted to the finance sector is clear.
For instance, in 1972 only five percent of Harvard undergraduates went into finance. By 1992, that had risen to 15 percent and approached nearly 20 percent in 2007. More broadly, the number of PhDs and Masters in finance awarded internationally has also grown.
It’s no mystery why. Financial incentives are significant. Prior to the 2008 crash, wages in finance were on average 40 percent higher than wages in other industries. But averages are one thing and they don’t emphasise enough the impact of the massive packages received by those at the top.
At the same time, there has been an increasing trend in the professionalisation of asset managers, with more people managing investments on behalf of others (individuals or organisations) with direct ownership of shares in the US equity market dropping from 47.9 percent in 1981 to 21.5 percent in 2007.
All this financial innovation has been complemented and accelerated by innovations in information technology. Asset prices respond to news faster than ever and markets are deeper, more integrated and increasingly globalised.
The cost of trading has dropped to a fraction of its previous cost and there has been an explosion in turnover, peaking at 215 percent (in the US) in 2007.
According to the efficient markets hypothesis, markets are informationally efficient – meaning that the price of a financial asset reflects all the information known about it. The asset price will change rapidly whenever new information becomes available. The smarter people are, the quicker they can unearth, interpret and make information available. Combine this with the 30-year revolution in communications technology that enables rapid – almost instant – dissemination of information, and you’d expect the smarter the markets become, the better they will be in terms of reaching true value pricing for assets faster and more accurately. The rapid availability of high quality information means efficient pricing and increased market stability.
Despite all this, the bubbles and crises in the markets have been coming more frequently. In some cases – such as the collapse of Long-Term Capital Management (LTCM) at the end of the 1990s, and more recently the subprime mortgage crisis, the smart guys have been directly implicated. After all, having Myron Scholes and Robert Merton – two Nobel Prize laureates for Economic Sciences – on the board of LTCM clearly didn’t prevent the company’s collapse.
So why are our supposedly sophisticated, agile and technologically advanced markets behaving in a way that is reminiscent of markets at the turn of the 19th century?
Momentum, competition and risk
In essence, there are three reasons why a large number of smart people makes markets more fragile. Firstly, more smart trend spotting means more momentum, both on the way up, and on the way down. Secondly and thirdly, the nature of competition on Wall Street, and the way practioners are compensated, both lead to riskier behaviour.
One of the things the smart guys have worked out is that following a trend – aka ‘momentum investing’ – is a profitable investment strategy. For example, if technology stocks are on an upward trend, it’s profitable to follow the trend and invest in technology stocks. The upward trend in prices will continue to a certain point. Of course, no one can accurately predict when this point is reached. There is likely to be eventual overshooting as the later trend chasers push the asset price beyond what the fundamentals would suggest its true value to be.
Nonetheless, trend chasing remains profitable on average, because even in smart markets, some people catch on quicker than others. Later investors – the ones that get the news last, or are slowest to act on it – stand to lose.
By identifying the profitability of trend chasing, the smart guys have popularised an investment strategy that, while largely profitable, creates price bubbles. Bubbles burst leading to market instability and, in the worst cases, market collapse.
Another way in which increased IQ on Wall Street contributes to instability is through competitive pressure, leading to risky behaviour. Job insecurity on Wall Street is higher than in other sectors, and it has increased in recent years due to the liquid labour market. This lack of security pushes ambitious traders towards strategies that yield profits with less regard for risk. And when employees are smarter than their managers, some of their actions or the nature of the risks they are taking may not be easily visible or readily understood.
What’s more, excessive compensation encourages risky behaviour, which throws wood on the fire; the amount of risk-taking that leverage enables, adds gasoline; and the conflicts of interest that emerge in some of the big finance institutions (for example, competing in two sides of a market trade such as buying and selling mortgages), further fan the flames.
So are smarter markets better markets?
Markets are as susceptible to bubbles and troughs as they were when they were much slower in their operation. But for very different reasons. Nonetheless, the genie won’t go back in the bottle. Governments cannot regulate IQ or employment patterns. But they can influence the rules of the game to decrease the attractiveness of risky behaviour and eliminate conflicts of interest.