Myth of the Rational Market

MythoftheRationalMarket pbFinancial markets were supposed to know better. They were supposed to be near-perfect processors of information and assessors of risk. They were supposed to be steering us toward a more prosperous, less economically volatile future. Then they failed, spectacularly. The Myth of the Rational Market tells the story of how we came to believe that financial markets knew best, and how that belief steered us wrong.

At least, that’s one way to describe it — I came up with that paragraph as the book was being published in the scary economic environment of June 2009. I had actually started work on Myth many years before the financial crisis, with no axe to grind or presentiments of doom. The inspiration was a book by Caltech finance scholar Peter Bossaerts that I encountered in 2002 in a stack of new releases at Fortune magazine, where I then worked.I couldn’t penetrate much of Bossaerts’ equation-filled argument, but in the introduction he seemed to be saying, in calm, non-argumentative tones, that the efficient market hypothesis’s day had passed. That was news to me. As a journalist who often wrote about the interactions between corporations and the stock market, I assumed that the academic consensus was still that financial markets got things right, could see through the transparent attempts by executives to make their companies’ earnings look better, and were almost impossible for even the most brilliant professional investors to outsmart — which together amounts to a loose definition of the efficient market hypothesis.

A bit of digging, though, revealed that the first part, about financial markets getting things right, had been largely abandoned, and the others were under fire. I had already known about Robert Shiller’s claims of “irrational exuberance” in the stock market. What I hadn’t realized was how much work by young scholars critical of the efficient markets mindset was being published in academic finance and economics journals — or that the tech-stock bubble of 1999 and 2000 had truly shaken the beliefs of some of the field’s old guard. Then the Nobel committee went and awarded half the 2002 economics prize to psychologist Daniel Kahneman, whose studies of real-world decision-making had brought into question the simple models of rational behavior that had underpinned post-World War II economics and finance.

So I set out to write an article for Fortune, which ended up being based mainly on interviews with Shiller, efficient-markets stalwart Eugene Fama, Kahneman collaborator Richard Thaler, and William Sharpe, who had won a Nobel in 1990 for the capital asset pricing model, a theory of the relationship between risk and return on financial markets that became tightly intertwined with the EMH. I also remember spending a bunch of time talking to Andrei Shleifer, who didn’t make it into the article, and reading and rereading Peter Bernstein’s Capital Ideas: The Improbable Origins of Modern Wall Street, a wonderful narrative of the rise of the EMH, CAPM, and several related concepts.

The article was published in Fortune’s annual Investor Guide in December 2002. The headline sums it up pretty well: “Is the Market Rational? No, Say the Experts. But Neither Are You — So Don’t Go Thinking You Can Outsmart It.” In those pre-social-media days, it was hard to tell if it made much of an impression. But I did get a lunch invitation from a book editor at HarperCollins, who told me I should expand the article into a book, and that he would like to publish it. He also told me to go find an agent. Nobody had ever said things like that to me before, so I complied with alacrity (it’s pretty easy to get an agent when you already have a publisher committed to buying your book), and a few months later I had a book contract with HarperCollins. Oh, and before then I took Peter Bernstein and his wife, Barbara, to lunch ask for their blessing — since the book would be a follow-up and partial refutation of Capital Ideas. I got not only that blessing but substantial help from Peter in crafting my book proposal. The man was (he died in 2009) a mensch, as well as an inspiration.

The contract said I was supposed to finish the book in 2004. I had no idea if that was realistic, but I figured book publishers didn’t really care about deadlines, right? So I started learning all I could about Irving Fisher, Holbrook Working, Ed Thorp, Jack Bogle, and many others, often got stuck on the theories I was trying to understand and lost in the stories I was researching and … finally turned in a complete manuscript sometime in the first half of 2008.

By then I’d been forced to accept a reduced advance and was on my fourth editor (the other three had all left HarperCollins). But my timing of course turned out to be unintentionally brilliant. I finished dealing with my editor’s suggestions just as the financial world was collapsing that autumn, and was able to write my introduction after Alan Greenspan’s famous my-model-of-the-world-was-wrong testimony to Congress in October 2008. So when Myth hit Amazon and a bunch of Barnes and Nobles on June 9, 2009 (the now-defunct Borders didn’t stock it at first, and hardly any independent sellers did either), it seemed extremely timely.

This led to the book getting lots more attention, and selling lots more copies, than would have happened otherwise. Links to the reviews are below, and I’ll just go ahead and link to the Daily Show appearance right here. Myth made brief appearances on the Wall Street Journal business bestseller list and the New York Times “extended” nonfiction list (that is, the list, published only online, of the books in 16th through 25th place). It also spent a few heady days jostling with Pride and Prejudice and Zombies and even Twilight in the upper reaches of Amazon’s bestseller list.

But while Myth was lucky enough to be a book of the moment for a few months in 2009, it was never intended to be a book of the moment. I embarked on the project because I thought it there was interesting and important story to tell about the rise and partial fall of a set of financial theories that had a big influence on the world, and I took six years to finish because I wanted to research it well enough and tell it well enough that it would last (well, that and because I’d never written a book before and had no real idea of what it entailed, and was working full-time for all about eight months during those six years).

And it has lasted. I set out to write a durable intellectual history — or at least a durable pop-intellectual history — and now that the book can no longer be seen as a timely commentary on a recent financial crisis, I think that is what it has turned out to be. I had to correct a few small errors pointed out by Fama, Thaler, and others as soon as the book came out, and since then I have often had occasion to wonder whether I shouldn’t have made mention of this economist or that paper in the book. But on the whole, the thing has held up really well. So, seriously, if you’ve read all the way to end of this and haven’t read The Myth of the Rational Market, just go buy it right now.


Twilight of the Efficient Markets, Cosmo Shalizi, American Scientist, November-December 2009. “Fox’s explanations of technical material are superbly accurate and readable … Clearly the result of many years of research and reading, the book is—its epilogue on the ongoing financial crisis notwithstanding—in no sense a rush job. Rather, it is a model of what the popularization of social science can be, but too rarely is, and it will continue to be read when the current crisis is many years behind us.”

“The Myth of the Rational Market” (no link available), Harvard Business Review, October 2009. An “insightful book.” Fox’s “smart journalistic eye and fine prose keep the theoretical discussion lively.”

School for Scoundrels, Paul Krugman, New York Times Book Review, Aug. 9, 2009. “Do we really need yet another book about the financial crisis? Yes, we do — because this one is different. … Fox’s book is not an idle exercise in intellectual history, which makes it a must-read for anyone who wants to understand the mess we’re in.”

Myth of the Rational Market: the rise and fall of the idea of market rationality, Cory Doctorow, boingboing, July 15, 2009. “[W]hat Fox has put together is a thoughtful, often fascinating, always illuminating history of the idea of market rationality, and the fortunes of the economists, bankers, regulators, philosophers and psychologists who’ve sought to explain the stormy seas of the market (and to get rich while doing it, of course).”

‘Myth of the Rational Market’ says you can’t predict stock market, Richard Eisenberg,USA Today, June 29, 2009. “Fox spends more than 300 yawn-inducing pages slogging through the rise and eventual fall of the rational-market theory (his 2002 Fortunearticle inspiring the book was far more interesting).”

Rational Man, Buttonwood’s notebook, “An intellectual tour-de-force … one of the two financial books I have enjoyed most this year.”

Slaves to Some Defunct EconomistThe Economist, June 11, 2009. “Fascinating and entertainingly told. … Mr Fox has written a worthy successor to Capital Ideas, the late Peter Bernstein’s 1990s classic on the emergence of the rational-market myth: bang up-to-date; alas, without the happy ending.”

The Price is (Usually) Right, Burton G. Malkiel, The Wall Street Journal, June 10, 2009. “Mr. Fox’s book is really a lively chapter in the history of ideas … Among much else, Mr. Fox presents lucid explanations of Portfolio Theory, the Capital Asset Pricing Model and Option Pricing Theory without the use of a single equation. And he brings the major players in his drama to life with an appealingly breezy style. … With The Myth of the Rational Market Mr. Fox has produced a valuable and highly readable history of risk and reward. He has not, however, been able to bury the hypothesis that our securities markets are usually remarkably efficient.”

Yale Oddball, Math Whiz Drove Efficient Market to Ruin, James Pressley, Bloomberg, June 9, 2009. “A rich history world’s most seductive investing idea, the efficient markets theory. The jacket copy is right to call this ‘an intellectual whodunit.’”

An Economic Model Turned to Myth, John Authers, Financial Times, June 8, 2009. An “excellent new history … impressively broad and richly researched.”

On Wall Street, the Price Isn’t Right, Roger Lowenstein, The Washington Post, June 7, 2009. “Fox … spins a fascinating historical narrative. … Fox recognizes that true believers in the market’s efficiency suffered from a ‘blinkered’ mindset and ‘tunnel vision.’ Yet I think he lets them off too easily.”

A Most Inefficient Theory, Glenn C. Altschuler, Barron’s, June 1, 2009. A “lucid, lively and learned account.”

The Myth of the Rational Market, Robert J. Hughes, SmartMoney, May 22, 2009. “What makes Fox’s book so rewarding and so readable is his way with the telling anecdote.”

The Myth of the Rational Market, Rob Horning, Popmatters, May 21, 2009. “The slurry of names sometimes muddles what is otherwise a lucid synthesis of the ideas that went into what Fox calls the rational market.”

The Myth of the Rational MarketPublishers Weekly, May 18, 2009 (ninth item down), starred review. “[T]he rare business history that reads like a thriller. … 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.”

The Myth of the Rational MarketLibrary Journal, May 15, 2009 (seventh review down), “Fox argues convincingly … The style here is journalistic, with personal stories that make the book entertaining, but ultimately this is a history of academic thought …”

Two Books, April 24, 2009. Menzie Chinn of the University of Wisconsin and Econbrowser discusses The Myth of the Rational Market and George Akerlof and Robert Shiller’s Animal Spirits: “They are both important books. Well worth reading.”

Other coverage

The price is not always right and markets can be wrong, Richard Thaler, Financial Times, Aug. 5, 2009. Economist Thaler praises Myth in an essay differentiated the “no free lunch” and “the price is right” versions of the efficient market hypothesis.

Poking Holes in a Theory of Markets, Joe Nocera, The New York Times, June 6, 2009. In his weekly column, Nocera calls Myth “an engaging history of what might be called the rise and fall of the efficient market hypothesis.”

De mythe van de rationele markt, April 14, 2009. Katrijn de Ronde of Dutch financial website z24 runs through the main arguments of the book. In Dutch.

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