An Insightful and Informative Book on the Grandest Financial Edifice

When the US subprime mortgage market took the nosedive in 2008, its ripples were felt all across the world. Not to mention the frightening consequences of the cascading effect that it generated. One domino after another came down crumbling. Some were bought over while others were left to go under. Often, it is in the catastrophic times like these that the long-standing, cherished doctrines are blown to bits, only to be replaced by new articles of faith that come to rule the roost until they also face the same fate. Justin Fox's 'The Myth of the Rational Market' is one such tale about a grand theory. A theory that brought a new dimension to the world of finance in the post WWII era, a theory that divided the world into two parts - an overwhelming majority and a miniscule fringe, an intellectual edifice in whose glorification Michael Jensen (creator of 'Alpha' - the risk-adjusted measure) once said," No other proposition in economics has more solid empirical evidence supporting it than the Efficient Market Hypothesis." Efficient Market Hypothesis (EMH) had an incredible run for over five decades in the world of finance until the holes in its facade became glaring enough for a countertheory to take over. Meltdown of 2008 has left the EMH and its followers in tatters. However, that doesn't mean the cult is dead yet. It's just that for the time being, baton has been passed over to a new counterculture - 'Behavioural Finance'.

Justin Fox is a business and economics columnist with 'Time' magazine and 'The Myth of the Rational Market' is an outcome of his personal interactions with the creator and proponent of EMH, Eugene Fama and Richard Thaler, the behavioural economist. Instead of delving into the annals of evolution of finance, Fox kicks things off from the events of early twentieth century when common stocks were mainly considered speculators' domain. In author's own words, prior to WWII, world of finance operated largely on Heuristics and on sets of wise observations. That investors are rational entities and always act independently on the basis of full and relevant information were some of the assumptions that traditional economics was based on. However, the 'financial domain' was devoid of any such encompassing model or framework. In the post war era, Harry Markowitz of University of Chicago revolutionized the world of finance when he originated the statistical approach to equating risk-reward (modern portfolio theory). Markowitz' work was soon complemented by UCLA's William Sharpe's CAPM (Capital Asset Pricing Model). Theories and models from the world of academics had started pervading the Wall Street. The professors behind these models had now started to turn into cult figures of sorts and along the course, they also learnt how to monetize their cult status big time.

Justin Fox introduces the EMH guru Eugene Fama in the sixth chapter of the book. Fama was the product of new-fangled Chicago Business school. EMH was Fama's Ph.D dissertation topic. While Fama was busy with his dissertation, two other Chicagoans Lorie and Fisher were scanning common stocks data of over three decades. The duo's study threw out an atypical conclusion - there was no evidence that stock selection skills of Mutual Fund managers were any better than a layman (This theory later proved to be instrumental to the formation of Index funds). According to Fox, Chicagoans were pretty convinced that no sort of information was enough to outsmart the market. All the information was already factored into the prices and there was no way for an investor to avail of a bargain price - this was the essence of Efficient Market Hypothesis. More specifically, EMH was based on the assumption that prices couldn't be wrong and if there are any discrepancies, well-informed investors would soon arbitrage them away (thus, fashioning a bell curve distribution). However, the evidence over the decades suggests something else. Stock markets often experience long periods of rallies even if the investors are well-informed of the discrepancies.

Conviction of Fama and his disciples about the 'random' direction of market made the bell-curve a significant representation of Efficient Market Hypothesis. And, this is precisely where they got it wrong! I would like to borrow from Nassim Nicholas Taleb (author of The Black Swan) here: It was EMH's failure to account for 'hidden tail risks' that blew up the society. Extreme, unpredictable events do happen in stock markets, courtesy the unpredictable human behaviour with an uncanny ability to generate fat tail risks, sometimes, from predictable variances (e.g. a small market correction turned into a panic).

'The Myth of the Rational Market' is a mammoth book yet it's entertaining, thanks largely to its lively written narrative and a very interesting chronicling of some famous and some infamous doctrines. Fox puts together an impressive star-cast to explain the rise and the presumed downfall of The Myth called EMH. So, you have everyone from Irving Fisher, Kenneth Arrow, John Maynard Keynes, Harry Markowitz, Fischer Black, Myron Scholes, Benjamin Graham, Warren Buffet, William Sharpe, Herbert Simon, Paul Samuelson, Eugene Fama, Benoit Mandelbrot, Daniel Kahneman to Robert Shiller and many more. Fox, it seems, has opted for a politically correct, middle-path approach as he shines the spotlight on both the contributors and the detractors of the Efficient Market theory. So, here's a book which tells you the story of once-revered edifice of finance but at the same time, overcautious in its restraint from maligning any historical figures. On the lighter side, Fox has written a book which deals with complex, circuitous world of finance yet he steers clear of mind-boggling stochastic equations and high-powered math (some may not find this aspect acceptable, though). For the starters in the field of finance, MBA students, and those who want to refresh their memories with valuable historical lessons, 'The Myth of the Rational Market' is a quintessential read.