The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street [Anglais] [Relié]

A few years ago business and economics journalist Justin Fox went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. He then went back to New York and wrote an article entitled "Is the Market Rational?" The headline for the article read "No, say the experts. But neither are you---so don't go thinking you can outsmart it." Out of this encounter came this pretty mammoth, extremely informative, and lively written narrative of modern financial economics. If you read this book and take its arguments seriously, you can avoid the major pitfalls that doom some investors to penury. On the other hand, if you think you can beat the market through personal testosterone and shrewdness, don't bother buying the book. Save your money. You'll be on the bread line soon enough.

Saying that people are irrational and the market is irrational is of course now all the rage. But, if you think you can romp your way to financial security by taming your animal spirits and feeding off the market's irrationality, I assure you, and Justin Fox assures you, that such is not the case. "While behaviorists and other critics have poked a lot of holes in the edifice of rational market finance, they haven't been willing to abandon that edifice." (p. 301). The reason is that the edifice is usually correct, although it can experience spectacular failures. The problem is that we don't know when it will experience these failures. We do know, or at least I strongly believe, that the failures are due to herd behavior of investors, which undermines the applicability of the normal statistical distribution, the mainstay of traditional financial theory.

The theory that financial markets are rational is called the Efficient Markets theory. It has two parts. The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can't gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming. If your stockbroker tells you he can pick winners, run as fast as you can. Indeed, the best policy is simply to invest in low-overhead mutual funds, and look VERY closely at the overhead. You'll do very well that way over the long haul. Trust me.

The second half of the efficient markets theory is that market imbalances cannot persist for more than a very short time, because as soon as they are discovered, they will be arbitraged away. There is fairly good evidence that this half of the theory is often wrong; the stock market, for instance, can suffer run-ups for long periods of time; everyone knows the market is out of balance, but no-one knows when to get off the gravy train. Moreover, a financial manager that fails when all others fail (e.g., after a melt-down) will not be blamed, but one who gets off the train too soon will be widely vilified and discredited. I recall that some economists were predicting a financial crisis a full three years before it actually occurred. This is okay for on-lookers, but real players cannot get off the train too soon. Whence the failure of the second half of efficient markets theory.

This book is an extremely valuable resource for the non-professional. There are no equations, but Fox gives one a pretty good idea of what assumptions lie behind a theory, and what arguments and data can be erected for and against it. Financial economics is about the most difficult area of economics because it uses very high-powered math, including stochastic differential equations. The huge amount of financial data makes it relatively easy to test financial theories, so we know fairly well what works and what doesn't. Fox does a totally convincing job of being balanced without ever being boring or simply taking the middle-road. The book deserves it widespread popularity.

Overall, Fox has written a very good book which covers a remarkable amount of material in only 322 pages. The problem is that this book, if properly done, should run around 600+ pages. Granted, Fox is a journalist, not an academic, so his audience might not have an appetite for a book that takes a month to read, but the topic is interesting and important enough to warrant a more detailed discussion.

Fox's book is organized primarily by ideas and then chronologically. This can lead to jarring jumps between time periods within chapters and the reader suspects that important topics are being missed. The twelve-page epilogue for example begins in 1833 and is in the 1960's by the turn of the page.

The mathematics discussed in the book is not terribly complicated but the reader is given no formulas, no graphs, no applications of the quantitative theories. Yes, everyone knows what normal distribution looks like but the power laws discussed deserve a chart. Mandelbrot's fractal theories need a diagram. Fox would also support his argument more strongly if he included the formulas which were eventually altered by the behavioralists. Without these, the reader is forced to blindly trust what Fox is telling him.

Despite these minor criticisms, the book is definitely worth reading. I am guessing that the title attracts many readers who hope financial-economics moves beyond the Chicago School efficient-markets framework. If this is what readers want, I recommend Beinhocker's "The Origin of Wealth." If you want a quick tour of academic financial thought, read Fox.

Justin Fox has a great blog and writes for Time magazine, having previously written for Fortune magazine. So it was not a surprise that his book is well written and fast paced. Better yet, he has chosen to cover the most critical topic in all of finance: does the market correctly price stocks, bonds and real estates? In delivering a masterpiece he has either killed himself in thoroughly researching the subject or someone talented has directed him to all the right issues. He correctly dates the emergence of the efficient markets theory to the early twentieth century, then covers the contribution of Paul Samuelson, who is oddly enough always forgotten in any coverage about the efficient markets doctrine. He then goes through the sequence of Markowitz, Miller, Modigliani, Fama and Michael Jensen (an odd insertion indeed, since Jensen sweared by efficient markets theories but made his name emphasizing firm level inefficiencies, ones profitably eliminated by buyout funds, but whose profits would not be so impressive if the market could correctly price their coming contribution). He then introduces Richard Thaler and Robert Shiller, and thus downplays Amos Twersky and Daniel Kahneman, which is a failing of the book.

All in all it is a competent masterful history of financial theory and is a must buy for anyone with interest in investing. What it does not pretend to do is give readers a better idea of how to tackle market decisions. That is fine. What is not fine though, and what should be fixed in any future edition, is the lack of hard evidence on why markets are inefficient. There has to be a chapter on Warren Buffet and Peter Lynch and George Soros too, who made mince meat of efficient markets theories with the money they made. The point cannot be made from quotations of famous people alone. Had Justin Fox done that, he would have created a more complete book, what could even have been a classic. Also missing is the destruction derivatives have caused, and which are the offshoot of efficiency dogma. Once again Justin Fox tries to get off by a quotation here or there, but it is insufficient.