Baked in the Cake

F.A. Hayek: A Progenitor of Market Efficiency

Baked in the Cake


“I am convinced that if it [the price system of a free market] were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.”

--Friedrich von Hayek, The Use of Knowledge in Society, 1945

 

One of the cornerstones of IFA’s investment philosophy is that markets work. Free people pursuing their own best interests produce a far better allocation of resources than could be dictated by a small group of central planners. This simple idea was not always accepted as axiomatic. During World War II, the government assumed unprecedented powers in determining who could produce what, how much would be produced, and how the goods produced would be allocated between the military and the civilian population. As the U.S. emerged overwhelmingly victorious, many economists argued that it would be foolish to discontinue the central planning that had worked so well in wartime. Enter economist F.A. Hayek, the author of The Road to Serfdom, who published a landmark article in September of 1945, The Use of Knowledge in Society, which put forth the concept that prices in a free market are set by information that is available to market participants and serve as a means of communication between buyers and sellers. As perceived in the quote above, Hayek considered the price system to be “a marvel."

         

Joseph Chi and Jed Fogdall of Dimensional Fund Advisors beautifully explained it by noting that there are two types of information: (1) general knowledge widely available to all market participants and (2) specific knowledge of the particular circumstances of time and place, including the preferences and needs of each investor, which vary by investor. The price system aggregates both types of information, including the knowledge about the specific circumstances of all market participants, into one single statistic—the price—so that investors have the knowledge necessary to make decisions for themselves. Because both types of knowledge can move prices, market participants compete with one another to be the first to bring information not yet reflected in prices to the market and profit from it, but no participant has the full set of information, because each participant has some specific knowledge not generally available to others. That competition and interaction among market participants make market prices reflect information about fundamental values and expectations, with no single participant able to interact with the market in isolation, up to the point at which the marginal benefit of acting on information that is not reflected in prices (that is, the profits to be made) is at best equal to the marginal cost of gathering that information and acting on it.

The author of the Big Investment Lie, mathematician and economist Michael Edesess, takes it one step further by drawing an extended comparison between active fund managers and Communist central planners. Although the former would certainly disclaim any similarity with the latter, Edesess explains that by calculating a "true price" for a security that differs from the market price, active managers are exhibiting the same type of hubris as the central planners who thought they could decide the price and production of all goods, including the most mundane such as toothpaste. Like the central planners, the active managers only have a fraction of all the dispersed information that goes into determining the market price. Furthermore, like the centrally planned economies that ultimately collapsed, the overall results of active management have been sub-par. While Hayek used the price of tin as an example and discussed how it would change in the event of a supply shock or the discovery of a new use for it, he could just as easily have been talking about a financial instrument such as a share of General Electric stock. Hayek’s ideas about the wide dispersion of information combined with the ability of the price to aggregate all this information are central to the concept of market efficiency.

Hayek was awarded the Nobel Memorial Prize in Economics in 1974 and the Presidential Medal of Freedom in 1991 by President George H.W. Bush. IFA is pleased to feature him in Step 2: Nobel Laureates.