The Myth of the Rational Market
By Justin Fox
A book review by Richard Gill of the AIM & PLUS Newsletter
In the Myth of the Rational Market author Justin Fox, the business and economics columnist for Time magazine, explains why one of the most popular financial theories of the late 20th century is, as Yale professor Robert Shiller puts it “…one of the most remarkable errors in the history of economic thought”.
The theory that stock (and other financial) markets are rational is known as efficient markets theory. To put it simply the theory states that unless acting on inside information i.e. information which others do not have, investors will not be able to consistently outperform the market, except by chance. The argument is that the market, which is the sum of knowledge of all investors, is always right, and the combined knowledge always provides the best judge of the value of an asset.
While the academic evidence for the theory is claimed to be supportive, the theory is clearly nonsense. Would Warren Buffet, Anthony Bolton, Benjamin Graham, Peter Lynch et al have made their fortunes if the theory held true? Conversely, if the theory was correct then Nicola Horlick wouldn’t ‘t have done half as badly.
The theory also suggests that mis-pricings in the market can not last for very long. As soon as investors find an under/over valued stock they will react accordingly and change the price as soon as they can, according to the theory. This is also nonsense – take the dot.com boom at the start of the century or indeed any financial bubble and you will see that investors regularly over-price (and under-price) shares for long periods of time.
In the book Fox takes us through a history of how science tried to come up with an explanation of how financial market works. From the writings of economist Irving Fisher in 1905 we are taken through the development of the efficient market theory at the University of Chicago in the 1960s, its effect on the stock market and present day thinking.
In general the book is easy to understand, with Fox’s talent as an experienced financial and economic journalist coming out. Sometimes however, the language is a little too simple, with more explanations required of the maths behind the theories he discusses. Overall, the book is an entertaining and informative read which can be enjoyed by anyone from an economics student to a private investor.
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