The Myth of the Rational Market

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

by j fox


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73 of 77 people found the following review helpful:

5.0 out of 5 stars Don't believe the title, but read the book, July 16, 2009

By 

Herbert Gintis (Northampton, MA USA) - See all my reviews
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This review is from: The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Hardcover)

A few years ago business and economics journalist Justin Fox went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. He then went back to New York and wrote an article entitled "Is the Market Rational?" The headline for the article read "No, say the experts. But neither are you---so don't go thinking you can outsmart it." Out of this encounter came this pretty mammoth, extremely informative, and lively written narrative of modern financial economics. If you read this book and take its arguments seriously, you can avoid the major pitfalls that doom some investors to penury. On the other hand, if you think you can beat the market through personal testosterone and shrewdness, don't bother buying the book. Save your money. You'll be on the bread line soon enough.

Saying that people are irrational and the market is irrational is of course now all the rage. But, if you think you can romp your way to financial security by taming your animal spirits and feeding off the market's irrationality, I assure you, and Justin Fox assures you, that such is not the case. "While behaviorists and other critics have poked a lot of holes in the edifice of rational market finance, they haven't been willing to abandon that edifice." (p. 301). The reason is that the edifice is usually correct, although it can experience spectacular failures. The problem is that we don't know when it will experience these failures. We do know, or at least I strongly believe, that the failures are due to herd behavior of investors, which undermines the applicability of the normal statistical distribution, the mainstay of traditional financial theory.

The theory that financial markets are rational is called the Efficient Markets theory. It has two parts. The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can't gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming. If your stockbroker tells you he can pick winners, run as fast as you can. Indeed, the best policy is simply to invest in low-overhead mutual funds, and look VERY closely at the overhead. You'll do very well that way over the long haul. Trust me.


The second half of the efficient markets theory is that market imbalances cannot persist for more than a very short time, because as soon as they are discovered, they will be arbitraged away. There is fairly good evidence that this half of the theory is often wrong; the stock market, for instance, can suffer run-ups for long periods of time; everyone knows the market is out of balance, but no-one knows when to get off the gravy train. Moreover, a financial manager that fails when all others fail (e.g., after a melt-down) will not be blamed, but one who gets off the train too soon will be widely vilified and discredited. I recall that some economists were predicting a financial crisis a full three years before it actually occurred. This is okay for on-lookers, but real players cannot get off the train too soon. Whence the failure of the second half of efficient markets theory.

This book is an extremely valuable resource for the non-professional. There are no equations, but Fox gives one a pretty good idea of what assumptions lie behind a theory, and what arguments and data can be erected for and against it. Financial economics is about the most difficult area of economics because it uses very high-powered math, including stochastic differential equations. The huge amount of financial data makes it relatively easy to test financial theories, so we know fairly well what works and what doesn't. Fox does a totally convincing job of being balanced without ever being boring or simply taking the middle-road. The book deserves it widespread popularity.

http://www.amazon.com/Myth-Rational-Market-History-Delusion/dp/0060598999