« Sizing Up the Underwriters: A Five-Year Perspective on Underwriter Performance | Main | Even Rainmakers Suffer Consequences for Alienating Coworkers »


Book Review: The Myth of the Rational Market

Click to Print This Page

The Myth of the Rational Market After the successive crashes of the past decade, the premise that markets can be irrational is a foregone conclusion for most. Nevertheless, there is no denying that financial theory, which assumes market rationality, has made key financial innovations possible. Justin Fox’s The Myth of the Rational Market is rich in detailed, meticulous descriptions of the evolution of financial theory, presented via a veritable Who’s Who of financial luminaries from the past century. In the course of this history, Fox provides wonderful anecdotes about characters famous, infamous, and obscure, rendering their competitive and sometimes eccentric personalities with skill.

The genesis of rational, quantitative finance begins at the turn of the last century with the observation that price changes are random and are almost distributed normally. From there, conceptualizing an investment as a bet in payoffs fluctuating around an expected return plus a random factor led to the concept of arbitrage-induced equilibrium, to equations able to capture the “right” price, and to various forms of the efficient market hypothesis. Fox points out that the rational school requires more than mathematical proofs—it needs theory to unite data with logic. Adam Smith’s invisible hand—directing markets to the right price—was aligned with most people’s ideas of a well-functioning economy and contributed to the ascension of rational finance.

Once rational theory was firmly in place, both theoretical and product-based innovation followed. The capital asset pricing model, the Black–Scholes options model, and index-based mutual funds are among the direct descendents of this theory. Fox observes the ease with which these concepts were adopted by corporate management as rational theory gained dominance—for example, options-based incentives galvanized management’s pursuit of shareholder value.

From the beginning, there was tension between enthusiasts who embraced the rational perspective and doubters reluctant to discount the human element and suspicious of model precision. The criticisms of the latter group have now been formally voiced by thinkers in the field of behavioral finance, who have documented many pricing anomalies that should never have existed if markets were rational. The fact that the 1987 stock market crash was so far outside the bounds of a normal distribution curve made more room for the behavioral view and spurred the rational school toward introspection. As a result, a three-factor model was developed to better explain returns. To the overall market factor, it added size and value factors in order to isolate the superior returns of small and “value” companies over long periods. But Fox dismisses this model as “clunky,” based on data mining, and resting on dubious explanations. This is a harsh assessment. Many researchers regard the three-factor model as a landmark advancement in its own right, and as the impetus for explorations into the impact of momentum, liquidity, and other return factors.

In proposing practical lessons for the investing public, Fox straddles the tenets of behavioral finance and rational markets. In a nod to rational markets, he maintains investors should begin by asking why prices do not already reflect their insights. Limits to arbitrage are real and may be the culprit behind distorted prices. He favors low-cost index funds for investors without industry insight or private information, since selecting active managers requires an understanding of the managers’ strategies, something past track records don’t reveal.

On the other hand, for individuals who have industry knowledge or are able to sniff out securities that have simply fallen out of favor, he recommends analysis of relative rather than absolute prices to identify securities that are not priced rationally and are likely to deliver superior returns. However, he does not give a sense of the ability required to dig deep into valuations in order to avoid investments in industries going down the tubes. Although his active approach to security selection is mindful of behavioral traps, he may be overestimating the public’s discipline. Indeed, in an early section of the book, he cites behavioral research that portrays active investors who typically “traded way too much, chased after stocks that had been performing well,” and tended to buy hot funds. It draws a portrait of 401(k) investors “daunted by choice,” who failed to diversify, investing heavily in their own companies’ stocks. (In an unfortunate omission, Fox doesn’t speak to the need for tax-aware strategies or to the need to frame a plan with an investment policy statement.)

Fox’s encyclopedic knowledge of the evolving debate between the rational and behavioral schools lays an immensely valuable foundation for understanding where we are today. The debate on market efficiency is destined to rage on.

–Paul Tanner, CFA, is principal of Granite Hill Capital Management, LLC, in Ridgefield, Connecticut.

Related Posts Plugin for WordPress, Blogger...


Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.


Post a comment

Comments are moderated, and will not appear until the author has approved them.


NYSSA Job Center Search Results

To sign up for the jobs feed, click here.


NYSSA Market Forecast™: Investing In Turbulent Times
January 7, 2016

Join NYSSA to enjoy free member events and other benefits. You don't need to be a CFA charterholder to join!


CFA® Level I 4-Day Boot Camp

Thursday November 12, 2015
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session A Monday

Monday January 11, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session A Wednesday

Wednesday January 13, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session B Thursday
Thursday January 21, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session B Tuesday
Thursday January 26, 2016
Instructor: O. Nathan Ronen, CFA