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"Justin Fox is a truly insightful fellow who can see things with his own eyes--a rare, very rare attribute."—Nassim Nicholas Taleb, author of The Black Swan
"This wise and witty book is must reading for anyone who wonders what makes financial markets tick. Even those who have wrestled with this question for years will be glad to have read Fox's compelling history." —Peter Bernstein, author of Against the Gods and Capital Ideas
CHRONICLING the rise and fall of the efficient market theory and the century-long making of the modern financial industry, Justin Fox's The Myth of the Rational Market is as much an intellectual whodunit as a cultural history of the perils and possibilities of risk. The book brings to life the people and ideas that forged modern finance and investing, from the formative days of Wall Street through the Great Depression and into the financial calamity of today. It's a tale that features professors who made and lost fortunes, battled fiercely over ideas, beat the house in blackjack, wrote bestselling books, and played major roles on the world stage. It's also a tale of Wall Street's evolution, the power of the market to generate wealth and wreak havoc, and free market capitalism¹s war with itself.
The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth. It has been the maker and loser of fortunes, the driver of trillions of dollars, the inspiration for index funds and vast new derivatives markets, and the guidepost for thousands of careers. The theory holds that the market is always right, and that the decisions of millions of rational investors, all acting on information to outsmart one another, always provide the best judge of a stock's value. That myth is crumbling.
Celebrated journalist and columnist Fox introduces a new wave of economists and scholars who no longer teach that investors are rational or that the markets are always right. Many of them now agree with Yale professor Robert Shiller that the efficient markets theory "represents one of the most remarkable errors in the history of economic thought." Today the theory has given way to counterintuitive hypotheses about human behavior, psychological models of decision making, and the irrationality of the markets. Investors overreact, underreact, and make irrational decisions based on imperfect data. In his landmark treatment of the history of the world's markets, Fox uncovers the new ideas that may come to drive the market in the century ahead.
At the core of the current financial crisis has been the widely held assumption that markets behave rationally. Fox, Time magazine editor-at-large, isn't the first to bring scrutiny-or censure-to the conceit, but his analysis is singularly compelling, and the rare business history that reads like a thriller. Fox leads us on a chronological journey of modern economic theory, featuring the cast of scholars who constructed the 20th- and 21st-century financial landscape, from Irving Fisher to such post-WWII figures as Milton Friedman, Harry Markowitz, Franco Modigliani and Merton Miller, Jack Treynor and William Sharpe. Fox offers a behind-the-scenes glimpse at academia's finest, complete with amusing anecdotes about the players and their theories, and illustrates how our economic behaviors and markets have been shaped by a gradually refined theory holding that the stock market prices are both random and perfectly rational. A must-read for anyone interested in the markets, our economy or government, this dense but spellbinding work brings modern finance and economics to life. (July)Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved.
Fox, a Time editor at large and economics columnist, here takes readers through the history of academic research on financial markets since the late 19th century. He focuses on the development of the Efficient Market Theory and its fall from dominance, which resulted largely from the rise of behavioral finance. The Efficient Market Theory uses mathematical models to show that investors act on information as it becomes available, making pricing so efficient that an investor would be unable to beat the market without insider information. Fox argues convincingly that this theory has been eclipsed by behavioral finance, which studies investors' psychology to show that markets are not as rational as the Efficient Market Theory presents. The style here is journalistic, with personal stories that make the book entertaining, but ultimately this is a history of academic thought-complete with endnotes-and is best suited for students of finance or people interested in financial theory.
—Robbie Allen
Introduction: It Had Been Working So Exceptionally Well xi
Early Days
1 Irving Fisher Loses His Briefcase, and Then His Fortune 3
The first serious try to impose reason and science upon the market comes in the early decades of the twentieth century. It doesn't work out so well.
2 A Random Walk from Fred Macaulay to Holbrook Working 26
Statistics and mathematics begin to find their way into the economic mainstream in the 1930s, setting the stage for big changes to come.
The Rise, of the Rational Market
3 Harry Markowitz Brings Statistical Man to the Stock Market 47
The modern quantitative approach to investing is assembled out of equal parts poker strategy and World War II gunnery experience.
4 A Random Walk from Paul Samuelson to Paul Samuelson 60
The proposition that stock movements are mostly unpredictable goes from intellectual curiosity to centerpiece of an academic movement.
5 Modigliani and Miller Arrive at A Simplifying Assumption 75
Finance, the business school version of economics, is transformed from a field of empirical research and rules of thumb to one ruled by theory.
6 Gene Fama Makes the Best Proposition in Economics 89
At the University of Chicago's Business School in the 1960s, the argument that the market is hard to outsmart grows into a conviction that it is perfect.
The Conquest of Wall Street
7 Jack Bogle Takes on the Performance Cult (And Wins) 111
The lesson that maybe it's not even worth trying to beat the market makes its circuitous way into the investment business.
8 Fischer Black Chooses to Focus on the Probable 132
Finance scholars figure out some ways to measure and control risk. More important, they figure out how to get paid for doing so.
9 Michael Jensen Gets Corporations to Obey the Market 153
The efficient market meets corporate America. Hostile takeovers and lots of talk about shareholder value ensue.
The Challenge
10 Dick Thaler Gives Economic Man A Personality 175
Human nature begins to find its way back into economics in the 1970s, and economists begin to study how markets sometimes fail.
11 Bob Shiller Points Out the Most Remarkable Error 191
Some troublemaking young economists demonstrate that convincing evidence for financial market rationality is sadly lacking.
12 Beating the Market with Warren Buffett and Ed Thorp 211
Just because professional investors as a group can't reliably outperform the market doesn't mean that some professional investors can't.
13 Alan Greenspan Stops A Random Plunge Down Wall Street 227
The crash of 1987 exposes big flaws in the rational finance view of risk. But a rescue by the Federal Reserve averts a full reexamination.
The Fall
14 Andrei Shleifer Moves Beyond Rabbi Economics 247
The efficient market's critics triumph by showing why irrational market forces can sometimes be just as pervasive as the rational ones.
15 Mike Jensen Changes His Mind About the Corporation 265
The argument that financial markets should always set the priorities-for corporations and for society-loses its most important champion.
16 Gene Fama and Dick Thaler Knock Each Other Out 287
Where has the debate over market rationality ended up? In something more than a draw and less than a resounding victory.
Epilogue: The Anatomy of A Financial Crisis 309
Afterword 323
Cast of Characters 329
Acknowledgments 337
A Note on Sources 339
Notes 341
Index 379
Rational_Economist
Posted August 13, 2010
I Also Recommend:
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.
Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.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.
Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.Anonymous
Posted August 29, 2009
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.
Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.Anonymous
Posted March 12, 2012
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.
Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.willyvan
Posted March 16, 2010
I Also Recommend:
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."
Rides3Wheels
Posted January 23, 2010
I Also Recommend:
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.
IP
Posted June 18, 2009
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.
Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.Anonymous
Posted June 9, 2009
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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Posted July 3, 2009
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Overview
"Justin Fox is a truly insightful fellow who can see things with his own eyes--a rare, very rare attribute."—Nassim Nicholas Taleb, author of The Black Swan
"This wise and witty book is must reading for anyone who wonders what makes financial markets tick. Even those who have wrestled with this question for years will be glad to have read Fox's compelling history." —Peter Bernstein, author of Against the Gods and Capital Ideas
CHRONICLING the rise and fall of the efficient market theory and the century-long making of the modern financial industry, Justin Fox's The Myth of the Rational Market is as much an intellectual whodunit as a cultural history of the perils and possibilities of risk....