The Myth of the Rational Market

Financial 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. Justin
Fox’s 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. Chronicling the rise and fall of efficient
market theory and its century-long role in the making of the modern
financial industry, the book is both history and intellectual whodunit.
It brings to life the people and ideas that forged modern finance and
investing, from the Great Depression and into the financial calamity of
today. It’s a tale largely about professors, but 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 capitalism’s
recurrent war with itself.

MythoftheRationalMarket hc c 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 driver of
trillions of investing dollars, the inspiration for index funds and
vast new derivatives markets. In its strongest form, the theory holds
that the decisions of millions of investors, all digging for
information and striving for an edge, inevitably add up to rational,
perfect markets. That belief has crumbled.

The Myth of the Rational Market introduces a new wave of scholars who no longer teach that
investors are rational or that markets are always right. Many now agree
with Yale professor Robert Shiller that efficient market theory
“represents one of the most remarkable errors in the history of
economic thought.” Today the theory is giving way to new hypotheses of
market behavior growing out of psychology, physics, evolutionary
biology—and even  traditional economics. In his landmark intellectual
history, Fox uncovers the new ideas that may drive markets in the
century ahead.

A Myth of the Rational Market Q&A

1.    What is the myth of the rational market?

Most simply, it’s the belief that financial markets can be relied upon
to get things right. In the context of my book, it refers to the
academic theory most commonly known as the efficient market
hypothesis—although I often refer to it as rational market theory
because that’s shorter and, for those of us who aren’t finance
professors, clearer.

2.    What is main takeaway of your book?

That financial markets possess many wonderful traits, but that
rationality is not always among them. And that relying on markets to be
right all the time can be a very dangerous thing to do.

3.    Does your book explain the current financial crisis or any aspect of it?

Yes. Financial decision-making and financial regulation had been
restructured over the past couple of decades around the notion that
market prices are correct. If market prices and formulas built around
market prices said one thing, the thinking went, then who was a Federal
Reserve chairman or investment bank CEO to say they were wrong? It was
a suspension of judgment on a mass scale, and it turned out really

4.    How is The Myth of Rational Market any different from other books on economic history?  What is its unique appeal?

I don’t know of any other book that tells the story of the rise and
fall of the idea that financial markets are always right. So that’s
unique. Beyond that, I’ve tried really hard to make the book exhaustive
without being exhausting. It’s written for the lay reader, but also
meant to withstand the scrutiny (I hope) of the academic reader.

5.    What are some of the practical lessons of the book and do they have any application to economic recovery?

The most important practical lesson of the book in the context of the
current economic situation is that financial markets don’t know
everything. They know a lot, and the signals they send shouldn’t be
completely ignored. But when the market decrees that a collateralized
debt obligation is worth a certain amount, or that a trader at Lehman
Brothers should be paid a certain amount, or that a speech by the
Treasury Secretary is no good, it often gets things entirely backwards.
Our society (and our financial markets) cannot survive and thrive if
all decisions are left to the market.

Oh, and one another practical lesson: Stocks are a much better long-run
investment when they’re cheap by historical standards (as measured by
price-to-earnings or price-to-book ratio) than when they’re expensive.

6.    Although rational market theory was at first controversial, why did it become so widely accepted as standard practice?

First of all, because the facts seemed to back it up. For example:
Finance scholars argued in the mid-1960s that the superstar mutual fund
managers of the day were beating the market only by taking crazy risks
that would eventually backfire. Within a couple of years, most of those
stars had flamed out. More broadly, rational market theory offered
straightforward answers—some of them correct—to a lot of questions that
had long plagued investors, corporate managers and regulators.

7.    In recent decades, you note the theory traveled beyond the stock
market to apply to other securities and especially to what came to be
known as derivatives. Do you think this played a major role in the
current economic crisis?

Yes it did. Although it’s not perfectly rational all the time, the
stock market does process information quickly and handles even really
bad news in a mostly orderly fashion. The same can usually be said for
the organized exchanges in derivatives such as stock options and
commodity futures. The off-exchange markets for mortgage securities and
over-the-counter derivatives never developed the rules and contingency
plans characteristic of well-established exchanges, yet were still
expected to perform the same functions. When hit by adversity in the
summer of 2007, many of these markets stopped functioning entirely.
That, as much as anything else, was what turned a financial problem
into a crisis.

8.    What can today’s investors learn from studying rational market theory?

The market isn’t rational, but neither am I. Over the course of
researching and writing this book, I actually moved more and more of my
investment portfolio into index funds. It wasn’t because I think nobody
can beat the indexes, or that currently prevailing market prices are by
definition right. But index funds charge the lowest fees, and I’ve
become increasingly  dubious that in my spare time I can pick stocks or
investment managers that will beat the market after fees.

For those with more time and perseverance than I possess, the big
lesson from the fall of rational market theory is that value investing
works—but it works in large part because it’s very hard to stick to.

9.    What do you see as the future of Wall Street?

We’ll have a long period of rethinking and relative sobriety, and then
make all the same mistakes (or at least similar ones) again in 50 years
or so.

10.     How did you come upon the idea of writing this book? And, how did you conduct the research?

The particular thing that got me started was encountering a book
in 2002 by a finance professor, Peter Bossaerts of Caltech, that said
the efficient market hypothesis had outlived its usefulness. What
interested me was that Bossaerts sounded almost wistful about it—he
wasn’t an efficient-market critic, just a realist. I knew there was a
debate about the efficient market. This was the first hint I got that
it was more or less over.

It led to a 2002 Fortune article titled “Is the Market Rational? No, say the experts. But neither are you, so don’t go thinking you can outsmart it.”
Which in turn led to a book contract, six months spent reading through
old academic journals at the New York Public Library and Columbia
Business School Library and interviewing economists and finance
scholars across the country, then years of thinking, writing, and much
more reading and interviewing. Oh, and lots of staring blankly at a
computer screen.