Harvard Business Review Friday April 16, 2010 The Efficient Community Hypothesis By : Umair Haque The visionary _Stowe Boyd_ (http://www.stoweboyd.com/) recently kindly invited me to give a talk at his awesome _Social Business Edge_ (http://www.edgewards.com/) conference next week. I couldn't make it, unfortunately — so here's the talk I was going to give instead. Enjoy!! "Why Are 25 Hedge Fund Managers Worth 658,000 teachers?" A poignant question that was recently posed to me _on Twitter_ (http://twitter.com/minutrition/status/12222187132) , it makes your head — and your heart — hurt. The answer has everything to do with the _Efficient Market Hypothesis_ (http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp) . Last weekend, the world's most eminent economists gathered at King's College, Cambridge. Their goal: soul searching — reflecting on not just the economic crisis, but on the crisis in modern economics, of which the EMH is a foundation. Much maligned, often misunderstood, here, paraphrased, is what the EMH _really says_ (http://ineteconomics.org/sites/inet.civicactions.net/files/inet%...@k%20paper%20session%202%20-%20siegel.pdf) . "The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. No matter what definition is used, the hypothesis does not claim that the market price is always right." Italics are mine. The upshot? Even when markets are efficient, they can still be of little social use, because they can result in dramatic mispricing. The result? Bubble, crash, and collapse: welcome back to 2009, 1989, or 1929. And that's where communities come in. I'd like to advance a hypothesis. Call it the Efficient Community Hypothesis. It says: where efficient markets incorporate "all known information," efficient communities incorporate "the best known information." An efficient market is a tool for sorting the largest quantity of info. But an efficient community is a tool for sorting the highest quality info. On its own, the EMH is simply about informational efficiency: that prices incorporate "all known information." Where it falls down is in terms of informational productivity: whether prices incorporate accurate, valid, and reliable information — high quality knowledge, instead of low-quality noise. Incorporating all known information doesn't mean incorporating good information. The point of communities is, when you think about it, to ensure that people and organizations don't just get any old information — but the right, the best information. They should filter out bad, inaccurate information from unreliable sources and replace it with its opposite. They are, in short, the economic mirror image of markets: where efficient markets ensure information efficiency, efficient communities ensure information productivity. I live in a part of a big city that's like a small town. My favorite local butcher, baker, and café — and I — are meshed together into a web of social ties and shared knowledge: a community. I know them, and they know me. I know their virtues, saving graces, idiosyncrasies, and their faults. I suspect that they know mine as well ("Umair? He'll buy one cappuccino and sit by the window writing furiously for hours — the miser!"). That's an efficient community. First, it creates high-quality shared knowledge. Second, that shared knowledge is a _public good_ (http://en.wikipedia.org/wiki/Public_good) . Third, That public good is the basis of trust. And it is trust that supports and nurtures the many product, service, and financial markets that exist within my neighborhood, because it sets unshakably strong incentives for good behavior. That's the theory. Here's the advice. Organizations that can seed efficient communities stand to gain a disruptive information advantage. How should you get started? _The meaning is the message_ (http://blogs.hbr.org/haque/2010/04/from_social_media_to_social_strategy.html) . The right use of social tools is to help make yesterday's organizations less antisocial, and do more meaningful stuff — stuff that really matters to people — instead. The ECH is powerful because suggests in no uncertain terms how to get started. Organizations are enmeshed in intricate, global webs of markets. But they're not enmeshed in communities. That's why most end up being viciously antisocial to begin with. People, truth, identity, reputation, values are the five elements of an efficient community. Efficient communities sort good information from bad by inducing people to reveal their true expectations and preferences — whether managers, customers, or investors. The hallmark of an efficient community is a lack of _the double-dealing and dishonesty_ (http://www.rollingstone.com/politics/story/32906678/looting_main_street/print) Wall Street's now famous for. How? By tying people to identities and reputations. When people are bound together, they develop shared values — which destroys the incentive to dissemble in the first place. Let's take that from tiny to huge. When Twitter creates ads that audiences have radically more control over, it's trying to build an efficient community that powers better marketing. _When newspapers rethink anonymous commenting_ (http://www.nytimes.com/2010/04/12/technology/12comments.html) , they're trying to build efficient communities that power better reporting. When some of Silicon Valley's smartest folks turn from tools to "_tummlers_ (http://tummelvision.tv/) ," they're trying to build efficient communities that power better companies. When formerly detached capital markets _take baby steps_ (http://www.sustainability-index.com/07_htmle/assessment/criteria.html) towards evaluating corporate governance info, they're trying to build efficient communities that power better industries. When financial regulators seek to build banks on "_contingent embedded capital_ (http://network.nationalpost.com/NP/blogs/tradingdesk/archive/2010/04/09/embedded-contingent-ca pital-great-idea-terrible-name.aspx) ," convertible debt that creates far stronger incentives for investors to engage with management, they're trying to build efficient communities that power _a better global economy_ (http://blogs.hbr.org/haque/2010/04/the_case_for_being_disruptivel.html) . Here's the disconnect. The communities that today's most common social tools and practices are yielding _are far from efficient_ (http://blogs.hbr.org/haque/2010/03/the_social_media_bubble.html) . For evidence about what today's communities are filtering, look at _what rises to the top of the socialscape_ (http://tweetmeme.com/) . Usually, it's stuff meant for people building communities — not information that's most productive for, well, the average Jane. Call it the navel-gazing effect. Today's social innovators start with social media — but a more powerful starting point is _social strategy_ (http://blogs.hbr.org/haque/2010/04/from_social_media_to_social_strategy.htm l) . Let's summarize. Markets need communities. Yesterday's institutions are _collapsing around us_ (http://blogs.hbr.org/haque/2009/11/whats_your_strategy_for_the_ne.html) . In their remnants and rubble lies a lesson. Perhaps the biggest reason 20th century institutions failed so badly is that they replaced communities with markets. Yesterday, the primacy of the EMH said: communities were historical anomalies, sources of friction and waste, unethical barriers to "free" trade and exchange. Today, the ECH says exactly the opposite: it is only when markets are held together by communities that markets can move past the boundaries of mere informational efficiency; that they can do more than just suck in "all known information," only to misprice everything from tech to houses to people to the future itself. A market without a community is like a bridge without pillars. It is a crisis waiting to happen. Without communities, markets are more and more prone to manipulation, crisis, and collapse — because the quality of information declines. Sound familiar? _It should_ (http://www.newyorker.com/talk/comment/2008/02/04/080204taco_talk_cassidy) . When we put markets and communities together, efficient communities filter the best information (about reputable buyers, sellers, products, services, etc) and weed out the bad information. Efficient communities send this filtered info to markets, who soak it up and yield more efficient prices. The results of market exchanges create new info that feeds back into the community — driving a more sustainable, smarter kind of growth. In markets alone, assets are never priced correctly, and fund managers earn mega-bucks. But in a market embedded in a community? Well, the tables might turn: Maybe 658,000 fund managers are worth 25 teachers. And maybe, just maybe, that's the future of the global macroeconomy. At the Lab, we've tested the ECH a little bit. We find that the very, very few organizations who are able to put markets and communities together turn their industries upside down — by turning orthodox economics inside out. As John Kay has recently said, the EMH is "_the bedrock of modern financial economics_ (http://www.johnkay.com/2010/04/14/economics-may-be-dismal-but-it-is-not-a-science/) ." The Efficient Community Hypothesis, in contrast, just might be the bedrock of economics meant for humans. So the question is this: how efficient is your community?
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