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The Myth of the Rational Market by Justin Fox (Fred Lum/Fred Lum/THE GLOBE AND MAIL)
The Myth of the Rational Market by Justin Fox (Fred Lum/Fred Lum/THE GLOBE AND MAIL)

Taking Stock

Sun finally sets on notion that markets are rational Add to ...

In the midst of researching a book on the rise and fall of the efficient market hypothesis, author Justin Fox had occasion to explain his subject to a bunch of Duke University finance scholars. Half of them exclaimed: "What fall?"

It's now two years later. And after another burst asset bubble and a monumental global financial collapse, even the die-hard proponents are searching for other ways of explaining how the world should be unfolding.

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The shaky hypothesis that had long dominated academic thinking about the markets has finally been buried under an avalanche of unforeseen calamities, uncontrolled greed and other seemingly irrational behaviours it couldn't possibly explain.

Put simply, the largely discredited efficient market hypothesis (EMH) holds that prices of stocks and other assets reflect all available information and that the markets as a whole are smarter than any individuals, who can't possibly hope to outperform them.

Mr. Fox, the "Curious Capitalist" columnist for Time magazine, notes that the "heavy reliance on calmly rational markets was to some extent the artifact of a regulated, relatively conservative financial era."

In more recent times, EMH proponents have had to accommodate big anomalies.



Nothing in the hypothesis can explain speculative bubbles and busts, bizarre stock valuations and the inconvenient truth that some shrewd investors can indeed do better than the market. No wonder Yale Professor Robert Shiller once labelled it "one of the most remarkable errors in the history of economic thought." And that was back in 1984.

Yet starting in the 1970s, the theory paved the way for a slew of modern investing and risk-management methods. It also provided the intellectual underpinning for the exuberantly embraced deregulation that enabled Wall Street investment banks to eventually blow themselves up in an orgy of excess.

Among other innovations, we can thank the more practically minded EMH adherents for giving us option-pricing models, risk-weighted portfolios and index funds (if it's impossible to beat the market, why try?). These are also the math whizzes who conjured up the wonderful world of derivatives, securitized mortgages and the like, which were supposed to spread and reduce risk. Instead, they spread contagion and reduced their investors to tears.

"All of these finance guys assumed that the market performance of whatever period that they were able to measure would be a good representation of what the future would be like," says Mr. Fox, whose lucid book, The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street (HarperCollins), has attracted far more interest than your average tome on economic thought, thanks to its fortuitous timing.

And what the theoreticians were primarily measuring was the relatively long period of market stability stretching from the end of the Second World War to the 1970s.

"It's this general human trait, and it seems to have been picked up by the finance professors and a lot of the quantitative types on Wall Street. It's this naive willingness to assume that the past is a pretty good guide to the future," Mr. Fox said in an interview.

It has long been apparent to anyone actually involved in the markets that they are far from always right, that they can be thoroughly irrational and that they can diverge from economic reality for long stretches.

"One of the more interesting features of financial markets is that even if something is sort of a correct observation, once enough people come around to believe it, it stops working," Mr. Fox says. "Every good idea on Wall Street eventually becomes a bad idea. That's just the way markets work."

Yet the failure of the EMH hasn't stopped the deep thinkers from trying to come up with another all-encompassing theory to explain what the heck is going on.

The increasingly influential financial behaviourists would have us believe they have all the answers. But Mr. Fox doesn't buy that either.

"Clearly, the prices on the market are more volatile, less reliable, less rational than is envisioned in any of the rational market theories. But it's not like there are these great answers out of psychology that explain how everything works," he says.

The fact is there is no economics version of string theory that neatly ties together all the pieces of the complex financial markets puzzle. And that's because the whole thing is still as much art as science.

Follow on Twitter: @bmilnerglobe

 

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