The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

The Myth Behind The Myth of the Rational Market

A fairly well-written historical analysis of the 20th and early 21st century economy, and presents a persuasive case for increased government intervention in the economy. However, this case is made through omitting certain key pieces of information, and turning the focus away from the government--as many a liberal economists do when analyzing recessions. It also follows the outdated economics 1.0 models, by viewing the market as relatively static, while forgetting about innovation and the entrepreneur's key role in the market. I would recommend, rather than reading from the Harvard-MIT liberal economists or even the University of Chicago economists (although they are more enlightened than their east-coast counterparts), reading material from the Austrian school of economics--e.g. F.A. Hayek--as they predicted the recent international recession years before it took place. If you shed light on certain aspects of the economy--part of the focus of this book--you can see how the government seems to swoop in and save the entire country from the greed of the capitalists, giving the case for increased intervention. However, by viewing the whole picture, one can see how statism in the past has not only harmed our economy, but continues to harm the economies and standards of living for people all around the globe living in countries not as economically free as the US and Britain. On its surface, this book seems convincing; but by delving deeper, one can see the fallacies such arguments present (e.g. Keynesian economics and how many theories, such as the broken window theory, focus on the outcomes of certain people and the short-term while forgetting the effect on the entire economy or the long term.). This goes for all of history: if the author or historian focuses on one piece, his argument can always be a convincing one. Therefore, i recommend the following books, in hopes that you enlighten yourself and others around you (Patriot's history seems out of place, but it not so much debunks as it does adds a bigger picture than the neo-Marxist and limited focus of American History presented in People's History). Keep reading America!

1 out of 2 people found this review helpful.

Thank You for Dispelling the Myth

I think it is a very important book for anybody involved in the active money management. I really enjoyed the book because it explains that the rational market theory started as a hypothesis or a scientific model that oversimplified reality. As the model became more popular, many of its nuances and assumptions were lost. The rational market hypothesis became a theory.

One of my biggest philosophical difficulties with the efficient market theory is in the fact that it claims that it is not possible to beat the market over the long term. In the past, I was fortunate to work with several top-notch portfolio managers. These managers were able to beat the market over the long term. What separated them from other managers was that they had clear strategies for analyzing and trading stocks. Specifics of these strategies were not common in the industry. It took these managers years to develop their strategies. After they developed the strategies, these investors did not jump around to other strategies, even when prices of stocks in their portfolios were going down. Their innovation in developing their strategies and focus on using their strategies consistently allowed them to outperform the market dramatically over the long term.

Looking at achieving excellence from a wider perspective, I could not understand why people could excel in other endeavors (business, entertainment, sports, etc.) by applying their unique strategy, superior talent, hard work, or a combination thereof. However, according to the efficient market theory in investing one could beat the market in the long run only by chance. In my opinion, Lance Armstrong did not win Tour de France seven times just by chance; and neither did Warren Buffett put up his investment performance by pure luck. Both of them have relied on their long-term strategies and endurance in the face of difficulties to win in their respective fields.

Like in other areas of human pursuit, in investing it is difficult but not impossible for a person or a firm to reach excellence and beat competitors in the process. In my understanding, three necessary conditions for this include identifying a market niche in which one has very deep knowledge, developing a clear and consistent strategy to dominate the niche, and applying this strategy both in good and bad times.

Justin Fox, thank you for writing a stimulating and thought-provoking book!

1 out of 1 people found this review helpful.

Great book except not what the title suggests

The book is much less about why the rational market theories are wrong and more about their development history. It is superb in its description of how the theories developed, the personalities that defined them, the theories' somewhat accidental popularization despite most of the proponents having doubts from the start and most importantly, the linkages between most major developers (teacher-student, peers, family relations, rivalries etc).

As good as the book is, it fails to sufficiently describe the logical flaws which is perhaps what those attracted to the book's title are looking for. When one thinks about it, it is really strange that a theory that was designed to describe some human institutions (markets) and their processes, and not an idyllic exercise in rationality, almost never moved away from the examples of one single market - American stock market.

While the US markets themselves are irrational, if someone had tried to apply the same logic in other markets, the fallacy of the efficiency logic and calculations would have been evident much earlier (unless of course one did not try to explain away by the assumption that rationality is the domain of people operating in specific markets). Also, it is strange why the same theories were almost never attempted on non-equity markets (how about defining beta for properties in various locations or commodities or currencies!!).

It is also interesting to note that almost all the people involved in the efficient market theory and those in the opposition are Americans or at least professors in American universities. This is not just particularly odd but should have many other implications - the spread of one set of market ideas across the world without sufficient new thoughts or debates by anyone else. Odd that no Japanese, Chinese, Indian, French or German tried to come up with new capital theories or calculations by looking at their own markets but all kept on using formulas supplied by a set of academicians that at best worked in one financial market.

The book makes one think in many other directions and that's its biggest achievement. Certainly a must read but expect it to turn dated soon as the space is changing rapidly and many more are expected to expound on the subject in near future.

1 out of 1 people found this review helpful.

Excellent

A fascinating history of the development of the efficient market theory. One of the best economics / finance books that I've read in a very long time. I highly recommend it.

Fine study of the irrational market

In this fascinating book, Justin Fox, the business and economics columnist for Time magazine, charts the rise and fall of the myth of the efficient market. This notion was mostly American in origin, so Fox tells its story in a few universities, including, crucially, Chicago. Fox shows how life has exploded the idea that the market can rationally process information and allocates resources efficiently to the optimal use.

This is in part a history of those looking for a sure-fire way of making money from the stock market. They share the fantasy that they can know where share prices are going and the level of risk, and that they can produce a 'scientific forecast of the market'. Of course, when markets crash, most investing 'stars' crash too. If the market were efficient, surely speculators could never beat it?

But the crash of capitalism has crashed its theories too. As Alan Greenspan admitted, "the whole intellectual edifice collapsed." Adair Turner, chairman of the Financial Services Authority, said that we had experienced 'a fairly complete train wreck of a predominant theory of economics and finance'.

Clive Granger and Oskar Morgenstern's 1970 book, Predictability of stock market prices, said, "It is . a subterfuge going back at least to Adam Smith and David Ricardo to say that market price will always oscillate around the true (equilibrium) price. But since no methods are developed how to separate the oscillations from the basis, this is not an empirically testable assertion and it can be disregarded."

Eugene Fama, who had in the 1960s formulated the efficient market hypothesis, admitted in 1991, "Irrational bubbles in stock prices are indistinguishable from rational time-varying expected returns." There was no way to know if the market was irrationally volatile or not. He now believed that prices could go wrong and stay wrong: he no longer believed that prices were right.

Markets' behaviour determines the economic reality that market prices are supposed to reflect. The market is created subjectively; it does not reflect the real world.

The market is actually not about efficiently allocating capital but about giving speculative parasites chances to make vast profits with our money. As Larry Summers, Clinton's Treasury Secretary, concluded, "We might all be better off without a stock market."

Finally, a book about finance for reasonably bright people

In the Myth of the Rational Market, Justin Fox traces the history of finance through the 20th century and up through 2008. He does a solid job outlining the trends in both the economy and in economic theory and explicates the relationships and connections between them. His focus narrows to look closely at the rational market theory of the Chicago school led by Milton Friedman and others. He illustrates clearly how this theory, while slowly crumbling for decades, maintained a firm grip on both the government and the market for 40 years, survived many bumps in the road (multiple recessions, the savings and loan crisis, the dot com bubble) and ultimately, inevitably led us into the Great Recession.

The financially stable decades from Roosevelt's financial regulation in the 30s through the 1970s set the stage for the deregulation of Wall Street in the Reagan 80's and the predictable (in hindsight at least) decades of instability that followed. Detailed, documented, and persuasive, Fox makes a compelling case for a return to stability, a return to a productive balance between Wall Street's notion of a free market and the public's right to intervene effectively when Wall Street greed overcomes its sense of civic responsibility and common sense.

Great book on history of financial theories

This is a great book for novice investors and 1st year finance majors. I rememeber sitting in my first Finance class and the professor said: "Good luck trying to beat the market! It's efficient!" I wish I could read this book back then. The book is not comprehensive enough for professionals but for someone with general interest in history it is great. It is also good introduction for someone into financial world. It lacks in-depth research on derivatives but it is good as a first step into finance.

COMPLETE COMPREHENSIVE AND CLEVER

Justin Fox has a great blog and writes for Time magazine, having previously written for Fortune magazine. So it was not a surprise that his book is well written and fast paced. Better yet, he has chosen to cover the most critical topic in all of finance: does the market correctly price stocks, bonds and real estates? In delivering a masterpiece he has either killed himself in thoroughly researching the subject or someone talented has directed him to all the right issues. He correctly dates the emergence of the efficient markets theory to the early twentieth century, then covers the contribution of Paul Samuelson, who is oddly enough always forgotten in any coverage about the efficient markets doctrine. He then goes through the sequence of Markowitz, Miller, Modigliani, Fama and Michael Jensen (an odd insertion indeed, since Jensen sweared by efficient markets theories but made his name emphasizing firm level inefficiencies, ones profitably eliminated by buyout funds, but whose profits would not be so impressive if the market could correctly price their coming contribution). He then introduces Richard Thaler and Robert Shiller, and thus downplays Amos Twersky and Daniel Kahneman, which is a failing of the book.

All in all it is a competent masterful history of financial theory and is a must buy for anyone with interest in investing. What it does not pretend to do is give readers a better idea of how to tackle market decisions. That is fine. What is not fine though, and what should be fixed in any future edition, is the lack of hard evidence on why markets are inefficient. There has to be a chapter on Warren Buffet and Peter Lynch and George Soros too, who made mince meat of efficient markets theories with the money they made. The point cannot be made from quotations of famous people alone. Had Justin Fox done that, he would have created a more complete book, what could even have been a classic. Also missing is the destruction derivatives have caused, and which are the offshoot of efficiency dogma. Once again Justin Fox tries to get off by a quotation here or there, but it is insufficient.

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