The Myth of the Rational Market

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the myth of the rational

When the US subprime mortgage market took the nosedive in 2008, its ripples were felt across the world. The resulting cascading effect decimated one financial domino after another. Some institutions were rescued 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 a tale about one such 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 minuscule 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.”

Efficient Market Hypothesis (EMH) had an incredible run in the world of finance. Over five decades, it was put on pedestal and lionized in the corridors of ivy league institutions. The financial meltdown of 2008 left the EMH and its followers in tatters; the holes in its facade became glaring enough for a counter-theory to take over. The EMH-driven financial models flopped miserably in face of unpredictable and incomputable shocks. However, that doesn’t mean the cult is dead yet. It’s just that for the time being, baton has been passed over to ‘Behavioural Finance’.

‘The Myth of the Rational Market’ is an outcome of the author’s personal interactions with the creator and proponent of the EMH – Eugene Fama , and Richard Thaler, the behavioral economist. Fox starts off from the events of early twentieth century when common stocks were considered mainly speculators’ domain. In his own words, prior to WWII, world of finance operated largely on Heuristics and on sets of wise observations. The financial domain as such was devoid of an 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 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.

Justin Fox introduces the EMH guru Eugene Fama in the sixth chapter of the book. Fama was the product of Chicago Business school. EMH happened to be his Ph.D dissertation topic which he completed under the tutelage of Late Benoit Mandelbrot. It was the same Mandelbrot who later criticized EMH as a flawed theory with flawed underpinnings. 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 assumptions that prices are independent (today’s prices don’t influence tomorrow’s prices) and all the news is quickly incorporated into the prices. Still, if there are any discrepancies, well-informed investors would soon arbitrage them away (thus, fashioning a bell curve distribution).

EMH assumptions
(pic courtesy: http://www.businessinsider.com)

However, the evidence over the decades suggests something else! Stock markets often experience unpredictable, turbulent fluctuations and such periods of volatility often skip the radars of the most-informed investors. Even the bell-curve inspired models fail to capture the turbulence of financial markets.

Conviction of Fama and his disciples about the ‘random‘ direction of market made the bell-curve a significant representation of Efficient Markets 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 from unpredictable 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 downfall of the Myth called the Efficient Market Hypothesis. 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 as well as the detractors of the Efficient Market theory. So, here’s a book which tells you the story of a once-revered edifice of finance but at the same time, appears over-cautious in its restraint from maligning any historical figures. Fox also steers clear of mind-boggling financial mumbo jumbo 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.