The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Hardcover)

by Justin Fox (Author)

Editorial Reviews

From Publishers Weekly
Starred Review. At the core of the current financial crisis has been the widely held assumption that markets behave rationally. Fox, Time magazine editor-at-large, isn't the first to bring scrutiny—or censure—to the conceit, but his analysis is singularly compelling, and the rare business history that reads like a thriller. Fox leads us on a chronological journey of modern economic theory, featuring the cast of scholars who constructed the 20th- and 21st-century financial landscape, from Irving Fisher to such post-WWII figures as Milton Friedman, Harry Markowitz, Franco Modigliani and Merton Miller, Jack Treynor and William Sharpe. Fox offers a behind-the-scenes glimpse at academia's finest, complete with amusing anecdotes about the players and their theories, and illustrates how our economic behaviors and markets have been shaped by a gradually refined theory holding that the stock market prices are both random and perfectly rational. A must-read for anyone interested in the markets, our economy or government, this dense but spellbinding work brings modern finance and economics to life. (July)
Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved.

From The Washington Post
From The Washington Post's Book World/washingtonpost.com The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis. This theory holds that stock and bond markets are nearly perfect -- even during such crazes as the dot-com mania -- and that prices on the exchanges instantly and accurately reflect the available information about publicly traded securities. After the market crash of 1987, Yale University economist Robert Shiller called that belief "the most remarkable error in the history of economic theory." He could have said "most harmful error" as well. Yet it lived on and contributed mightily to the mortgage bust. One presumes from the title of Justin Fox's "The Myth of the Rational Market" that he has come to bury, not to praise. And certainly, the opportunity for such an undertaking is rich. Proceeding from the assumption that economic actors are unerringly rational, the theory's disciples have endowed market prices with the wisdom of every moment. Thus, at 2 p.m. on a Wednesday, the Dow Jones Industrial Average reflects the accumulated financial knowledge of civilization, and equally so at 2 on Thursday -- even if the market has moved hundreds of points in the interim. How did this faith in the supremacy of market group-think do us harm? For one, as the dot-com and other manias demonstrated, the crowd occasionally gets it wrong. The mistaken faith in markets turned regulators into fawning groupies. Notably, former Fed chairman Alan Greenspan doubted that he or anyone else could detect -- or regulate -- a bubble in advance. The power of the doctrine was its grand design: the comforting notion that the financial universe adhered to absolute laws. But that was also its flaw. Prices couldn't be wrong; if they were, someone would seek to profit from the error and correct it. The illustrative joke was of two economists who spot a $10 bill on the ground. One stoops to pick it up, whereupon the other interjects, "Don't. If it were really $10, it wouldn't be there anymore." Theorists such as Eugene Fama decreed that if prices are unforeseeable, then the future direction of the market is random. And if the market is truly random, prices should follow what mathematicians call a bell-curve distribution. In nature, this works. We don't know whether your neighbor will be tall or short, but we can predict, with pretty close approximation, how many very tall people will live in your town. In nature, extreme results such as a village of seven-footers will never occur. Fox tells the story of how financial engineers assumed that markets would behave the same way, with generally predictable variances in prices. In particular, the theory of option pricing, the cornerstone of modern finance, has built into it the assumption that prices are random. The theory was devised by Fischer Black, Myron Scholes and Robert Merton. The last two won the Nobel Prize in 1997 and were partners in Long-Term Capital Management, the hedge fund that blew up in 1998. What happened to LTCM? It turned out that in financial markets, extreme events do happen. People get emotional and decide to buy (or sell) in unison. All of LTCM's trades went sour simultaneously. Nonetheless, the modelers kept at it. Rating agencies assumed that subprime mortgagees would behave in random fashion -- large numbers of people would never default at the same time, right? (Oops.) Fox, a business columnist for Time, spins a fascinating historical narrative, beginning with economist Irving Fisher's paean to markets in, alas, 1929. Postwar economists such as Paul Samuelson noticed that most investment pros do not beat the averages. This led to the one positive contribution of the efficient-market hypothesis: Jack Bogle's invention of index funds, which mimic the performance of the stock market as a whole and keep ordinary people from wasting their money trying to beat it. Fox recognizes that true believers in the market's efficiency suffered from a "blinkered" mindset and "tunnel vision." Yet I think he lets them off too easily. He laments (as if it were necessary) the lack of any alternative "grand new theory" and finds that the debate has resulted in a "muddle." Fox concludes, "If you do come up with an idea for beating the market, you need a model that explains why everybody else isn't already doing the same thing." Not necessarily. Markets aren't physics. Maybe no one model explains them. The emerging school of behavioral finance fills in many of the gaps left by the efficient marketers. Behavioral finance, which Fox discusses at length, holds that financial man -- far from the perfect, mechanical trader depicted in textbooks -- is a rather neurotic fellow. He follows the crowd, fails to plan ahead and often makes mistakes. To think that his every price is perfect is a remarkable error indeed.
Copyright 2009, The Washington Post. All Rights Reserved.

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Product Details

• Hardcover: 400 pages
• Publisher: HarperBusiness (June 9, 2009)
• Language: English
• ISBN-10: 0060598999
• ISBN-13: 978-0060598990
• Product Dimensions: 9.1 x 6.3 x 1.4 inches
• Shipping Weight: 1.2 pounds (View shipping rates and policies)
• Average Customer Review: 4.1 out of 5 stars See all reviews (9 customer reviews)
• Amazon.com Sales Rank: #151 in Books (See Bestsellers in Books)

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Customer Reviews

Most Helpful Customer Reviews

42 of 44 people found the following review helpful:

5.0 out of 5 stars COMPREHENSIVE, COMPLETE AND CLEVER, June 9, 2009

By	Sanford "Sanford" (New York) - See all my reviews

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.

7 of 8 people found the following review helpful:

4.0 out of 5 stars Too Short, June 24, 2009

By	Samuel J. Sharp - See all my reviews (REAL NAME)

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.

5 of 6 people found the following review helpful:

5.0 out of 5 stars An excellent popular history of people and ideas, June 28, 2009

By	Aaron C. Brown (New York, New York United States) - See all my reviews (REAL NAME)

Fox covers a century of academic research and market events with remarkable comprehensiveness. He gets both the people and the ideas right, few popular accounts get even one out of two. Everyone, including me, will have some quibbles, a few people who did not get enough respect and some who got too much, some minor technical differences, but the book is absolutely fair. Perhaps most remarkably, it's fun to read.

Financial professionals should read this book to fill in gaps they may have in their knowledge of the history of the field, or to get a quick summary of theoretical changes since they left school. Serious non-professionals should make this their first choice for a general understanding of the field, before earlier classics like A Random Walk Down Wall Street, Irrational Exuberance, Stocks for the Long Run and Against the Gods. Those are all great books, but this one is better because it's comprehensive. The only competition should be John Bogle's Common Sense Investing which will give you more immediately practical advice, but a lot less history and theory.

One point previous reviewers either left out or disagree with is the title is misleading. This is not a book arguing that theories based on rational markets are wrong or bad. It describes how rational theories were built on solid theory and evidence, but grew into a myth both more extreme and more certain than was justified. They did a lot of good by displacing damaging inferior ideas, but also pushed aside a few important truths. Theory began to affect the market more than the market affected theory. After a period of reappraisal, rational markets are still vitally important, but theorists and practitioners have more nuanced and balanced understandings of their limitations.