Jesper Rudiger at the University of Copenhagen and Adrien Vigier of the University of Oslo show that, in some reasonable circumstances, markets can become stuck in a "reputational trap" in which mediocre advisors, bosses and fund managers thrive at the expense of better ones.
The first step towards such a trap occurs simply because random noise in share prices can cause even ordinary advisors or fund managers to do well: even a blind dog catches a rabbit sometimes. Because people mistake luck for skill, such advisors might earn themselves a good reputation. This then gives them a double advantage: they get new business from other clients as word of mouth spreads; and some of these clients will stick with him when his performance drops, because they won't want to admit to themselves that their prior faith in his abilities was mistaken. As the old proverb goes, give a man a reputation as an early riser and he can sleep til noon.
But won't the evidence of incompetence eventually become overwhelming? Not necessarily, say Professors Rudiger and Vigier. Because asset price fundamentals are volatile, even bad advice can sometimes come good. For example, someone who thought that quantitative easing in 2009 in the UK and US would cause hyper-inflation was obviously wildly wrong. But his advice to buy gold and index-linked bonds has done OK; these have risen 20 and 80 per cent respectively since then. It’s possible to be right for the wrong reasons.
Rudiger and Vigier's theory, though, is by no means the only one which predicts that quacks and mediocrities can stay in business. Bjorn-Christopher Witte at the University of Bamberg has shown that competition among fund managers can favour lucky risk-takers rather than consistent but less spectacular performers. And Brock Mendel and Andrei Schleifer at Harvard University have shown how rational but uninformed traders sometimes "chase noise"; they jump onto bandwagons in the mistaken belief that the smart money is behind them. When this happens, they can enrich fools who bought over-priced assets by making those assets even more over-priced; this was, in part, the story of the mortgage derivative market before the 2008 crash.
These are not merely temporary problems. Werner Troesken at the University of Pittsburgh has shown that the market for patent medicines in the US thrived for decades. One reason for this is that providers invested heavily in product differentiation so that when one medicine failed customers inferred not that the whole industry was a con, but instead simply shifted to another quack remedy.
Of course, these are no mere theories. Investors have learned the hard way that good reputations don't always make for good investments. In the 80s and 90s Equitable Life had a great reputation as a pensions provider - until it collapsed. In the tech bubble good fund managers such as the late Tony Dye were sacked while all sorts of shysters thrived. And Fred Goodwin was widely admired as RBS's chief executive until the bank collapsed.
There's a theoretical and a practical message here. The theoretical message is that markets don't necessarily weed out quacks; the notion that they tend towards a welfare-maximising optimum is sometimes an ideological fiction. The practical one is that backing reputations can be dangerous unless you have good reasons to think that a good reputation can itself be a source of continued good performance.
