Markets Can Never Be Perfectly Efficient

“Markets may be crazy, but this does not make you a psychiatrist.”

-Meir Statman

There are plenty of stories and anecdotes about how crazy markets can be, and I’m about to share one, but when we see these stories, it’s helpful to keep that Meir Statman quote in the back of your mind.

This story from Chaos Monkeys about the Goldman Sachs quant team circa 2005 shows why human beings prevent the market from ever being perfectly efficient:

On Friday afternoons, to shatter the preweekend slump, the entire desk would play an interesting game. Everybody chucked his or her corporate ID into a sack, and anted up something like twenty to one hundred dollars (higher ranks paid more). Then the head trader would remove the IDs one by one from the sack, calling out the names. The last ID in the sack got the entire pot. It was winner take all, and no splitting the pot at the end.

When there were only twenty or so IDs left, things got really interesting: a mob formed, and trading started. People with IDs left in the sack sold their IDs to the highest bidder, selling out early and monetizing rather than risking elimination. Fair value for an ID is a simple calculation: if the pot is $2,000 and there are 10 IDs left, then the option on one ID is just $2,000 ÷ 10 = $200. That’s not the way the market traded, though; IDs would inevitably sell for a premium, and the closer the process was to a close (i.e., the smaller the number of IDs left) the higher the premium got on a percentage basis. Mentally, people were irrationally willing to overbid for a large payout, and the likelier the payout, the more they’d overpay. Also, there were structural forces at work: it was Friday afternoon in New York, and people wanted the cash to blow on the weekend.

I bet that steak at Peter Luger tasted even better if it was bought with the trading floor’s money. The winner would pocket (if he could) the thick stack of twenties and hundreds, and everyone would take back his or her ID.

Rocket scientists that can calculate to the fiftieth decimal are no match against dopamine and adrenaline.

Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley