on July 16, 2009
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.
on June 24, 2009
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.
on November 27, 2009
I was intrigued when my Finance professor assigned The Myth of the Rational Market (TMRM) to our class as a supplement to the textbook. I'm something of a history buff and thought it might make for interesting reading. I was disappointed. The book has a bit of an identity crisis. It's likely a little too light for serious students of the subject, yet a little too technical for entertaining reading. Just as I would get familiar with (and interested in) a subject, Fox would move on to a new person. It became a little frustrating and I don't think I could recommend it to the casual reader. TMRM became the book I made myself read at least a little of each week, and that is unusual.
This isn't to say there weren't entertaining and educational parts. Justin Fox does a nice job in bringing the complex topics of efficient market theory, option-pricing models and CAPMs down to a layman's level. His research is impeccable and he highlights all the major players; Black, Fisher, Friedman, Keynes, Modigliani and Buffett, as well as a large cast of supporting players. Fox does a much better job, in my opinion however, with more "modern" economic figures than with the "founding fathers". His discussion of Mac McQuown's work at Wells Fargo to develop index-based mutual funds helped shed light for me on modern banking methods, and I now understand Michael Milken and the concept of junk bonds much better than before.
In both the "Early Days" section and the "Rise of the Rational Market" section, I felt like I was trying to drink from Niagara Falls with the deluge of names, places and theories. Without some kind of a personal reference to dates and eras, I felt all of the information simply washed over me. It wasn't until Fox began his "Conquest of Wall Street" section and through the end of the book, that I became truly interested in the subject matter again. I was able to connect the development of risk controls, hostile takeovers, stock options and the study of human nature to my own observations. My favorite chapters were probably those on Warren Buffett and Alan Greenspan. Fox seems to really dig into the subject of both men with a little more interest than many of the previous. I was able to satisfy my desire for details on each without feeling overwhelmed.
The Epilogue (The Anatomy of a Financial Crisis) was likely the most useful and interesting part of the entire book in my opinion. At last, this was the chapter I had hoped the entire book would be. It was simple, entertaining and educational. I finally understood a lot of what has gone on in the world of Fannie Maes and Freddie Macs. Subprime mortgages and Ponzi schemes became much clearer. I only wish the entire book had been written at this level. In the end, there is no clean wrap-up from Fox, but none should be expected. The financial market is an ongoing subject.
All in all, The Myth of the Rational Market is a decent overview on the subjects of the efficient market theory and Wall Street. It offers no answers and is difficult to slog through at times. If you can make it through the first half of the book, you will likely enjoy the second half much more. And you will find yourself educated, even if somewhat overwhelmed.
on June 9, 2009
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.
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.
on July 12, 2009
For better or for worse, the starting point for all discussions about capitalism and its failings is some sort of arbitrage principle. Let's look at the free-market argument against the possibility of racial discrimination in hiring, for instance. (I'm fairly certain I've read something like this in Posner.) Suppose you have a highly qualified black candidate who doesn't get hired, because his potential boss just doesn't like the color of his skin. The free-market response would be that someone else will swoop in and hire that person away -- may, in fact, hire him for less than an equally-qualified white candidate. Companies that are systematically racist in their hiring will be beaten by those that aren't.
There are two possible ways of interpreting the arbitrage principle in here. Either a) all companies will behave in a rational way, which would actually make racist hiring impossible, or b) some smart company will behave rationally, thereby beating its racist competitors. Inasmuch as we agree that racist hiring exists, we can rule out a). Besides, like any evolutionary-type argument, the claim isn't that all actors or all organisms act in a certain way, just that competitive pressure will eventually force a particular outcome.
In any case, even b) depends rather sensitively on the structure of the market. If there are infinitely many companies competing for customers, then even the tiniest inefficiency -- racism, say -- will be ruthlessly purged from the market. If there are only a few car manufacturers, on the other hand, then inefficiencies may last for a very long time.
You might be asking why I've even bothered to advance the infinitely-many-competitors alternative here. You might also be asking why I'm starting with an arbitrage principle rather than the rather more obvious fact there there exist racists in this world, and they don't act rationally. I think Paul Krugman hit on the answer in Development, Geography, and Economic Theory: putting the irrational elements of the human brain into a model turns out to be hard, at least if you're going to cross all your mathematical Ts and dot all your mathematical Is in the way that economists trust. Another way to put it is that the perfect-competition model fits together in a way that few rival theories have yet been able to match. The Myth of the Rational Market quotes Richard Thaler to the effect that it's the difference between being exactly wrong or being vaguely right: the alternative models know they're on to something, even if they haven't put all the pieces together yet.
I went into Myth thinking that it wouldn't understand the virtues of modeling -- that it would just be another hand-waving gesture against "those stupid economists." I have real problems with this anti-quantitative attitude. Modeling things mathematically has real virtues: speaking clearly, stating your assumptions as concisely as possible, and opening yourself up to the possibility of being proved wrong. More-orthodox economists are on to something when they suggest that behavioral economics is a collection of nice stories but nothing to build a theory on. By now it's clear to me that they're wrong about that, but their hearts are in the right place.
What's amazing about The Myth of the Rational Market is that it hits all these notes and many, many more. It explains what orthodox economists think, and why. It describes behavioral economics of the Thaler school. It describes behavioral finance of the sort that Andrei Shleifer, Larry Summers, and Brad DeLong are famous for. It describes Keynesian economics. It goes into the efficient-markets hypothesis at a decent depth. It follows Eugene Fama -- the father, if anyone can claim that title, of the EMH -- for a few decades, eventually catching him laughing at how much of a turn his own mind has taken. (Earlier, Justin Fox had found Fama praising the stock market after the 1987 crash: surely the market had just shown its genius, having collapsed quickly after it discovered new information. No one could identify what that new information might be, however. Free marketeers do often have a point that The Market Is Smarter Than You: just because an economist can't figure out why the market does something doesn't mean the economist is smarter than the market. However, it seems clear that the 1987 crash wasn't a shining hour for Efficient Market Hypothesis.)
In fact, The Myth of the Rational Market follows essentially all of the economics profession from Irving Fisher to the present, and ends ... at a draw, which is exactly where it should be. The orthodox economists are right that we need a good theoretical model of irrational behavior if we're going to do it right and if we're going to incorporate it into the successful body of rational-actor theory. The behavioral economists are right that there's too much anti-rational behavior to count it as mere diversions from "real" economics. Behavioral finance has contributed a lot to our understanding of the stock market: the concept of a noise trader, and how he interacts with a rational trader, is an important one. The fact that there are times (like now!) when arbitrageurs can't borrow as much money as they would need to capitalize on the market's irrationality, and that those times are precisely when they need money the most, is an unfortunately important one.
Fox even follows this historical evolution into places where I wouldn't have expected him to. He takes us to the Santa Fe Institute for a few paragraphs. Among other things, SFI tries to simulate, on a computer, many semi-rational economic actors buying and selling from one another, then watch the collective behavior of these simulated actors. For instance, do simulated imperfect humans ever cause a stock market to bubble and crash? Do arbitrage opportunities persist and, in fact, widen? This falls under the general heading of "microfoundations": deriving explanations for high-level phenomena out of the (partially) realistic behavior of low-level actors. If the high-level macrobehavior that fall out of the model look like the world we're used to, then that's a start. If the macrobehavior look right and the economic actors look like real, sometimes-irrational people, then we're on to something. My limited skim of the literature suggests that we're not there yet.
Whether we get the models right matters, as a glance as today's newspapers will tell you. Whether we assume that humans are perfectly rational actors feeds directly into how skeptically we view mortgage brokers: if mortgage buyers are rational, why bother protecting them from balloon mortgages? Why be concerned that they might let Enron zero out their 401(k)s? Humans need a bit of help here and there; rational actors don't.
All of this is in Fox's book, which is a page-turner intended for a wide audience. It covers a broad enough swath of the discipline that it has probably singlehandedly killed a dozen other, lesser books on a few dozen sub-areas of economics. I confess that I went into it expecting that it would be another opportunistic work, riding the coattails of behavioral economics or of the recent crash. It does neither; it will still be readable and informative and fun in a few decades. Highly recommended.
on July 19, 2009
Fox's book represents a substantial improvement over Bernstein's " Against the Gods " in that he demonstrates the intellectual bankruptcy of a profession that is primarily interested in maintaining the appearance of being " scientific " rather than being a science.Fox covers the issue but refrains from drawing the logical conclusion that a profession that uses no goodness of fit tests or exploratory data analysis BEFORE it assumes a normal (log normal) distribution is not a science at all but a profession that wants to maintain the appearance of being scientiific.
In his 1939-40 exchange with Tinbergen over Tinbergen's use of multiple correlation and regression analysis to explain changes in investment over the business cycle,Keynes asked Jan Tinbergen very politely to apply the Lexis Q test [ Keynes dealt with the special case nature of the normal distribution ,upon which multiple correlation and regression analysis rests,in chapters 17 and 33 ( A Treatise on Probability,1921,pp.414-422 ,especially footnote 1 on p.420)] to show or demonstrate that the time series data was homgeneous,uniform and dynamically stable over time.Tinbergen's response to Keynes contained no Lexis Q test ,no goodness of fit test ,and no exploratory data analysis.Tinbergen never supplied any such analysis to support any of his Normal distribution based multiple correlation and regression results in his lifetime.The answer is that Tinbergen JUST ASSUMED Normality.Keynes has been constantly attacked by econometricians ever since because he pointed out that they were just presuming in assuming a Normal distribution .In his last address before the econometricians before he died, Schumpeter,who was well aware of the regular irregularity of the time series data on investment,had bluntly told the econometricians that their multiple correlation and regression approach ,based on the Normal distribution,would not work.Schumpeter was ignored.
Fox is to be saluted because he brings this problem ,concerning the egregious misuse of the Normal distribution by an economics profession whose main goal is to look scientific, as opposed to being scientific,into the open with his discussion of the work of Benoit Mandelbrot.Bernstein attempted to cover this up.
Mandelbrot is a scientist.His examination of the evidence overwhelmingly demonstrated that the normal distribution could not be used in any study of financial markets due to the long,thick,fat tails and extreme kurtosis of the time series data in financial markets.Osborne,a normal distribution advocate ," told his students that Mandelbrot's ideas about infinite variance (the distribution that fits the time series data best is the Cauchy distribution .Its first two moments are infinite expectation and infinite variance) were " a stew of red herring and baloney ".Sure,there were jumps and dips in stock prices that couldn't be shoe-horned into a normal distribution...But for most purposes it was OK to ignore them " (p.135).What was the result of this anti-scientific approach by Osborne ? The result was this :" We were seeing things that were 25-standard deviation moves,several days in a row," said Goldman Sachs chief financial officer David Viniar in August 2007....Viniar's point seems to be that what had happened could not possibly have been predicted-a 25-standard deviation event should only occur every hundred thousand years.A better explanation may be that his risk models weren't very good ."(p.316).Keynes had pointed out what was wrong with using the normal distribution as a model for financial markets in his analogy with seaworthy ships being build to withstand the relatively rare ocean storm and not just the normal ocean weather.Unfortunately,modern financial markets are NOT built to withstand financial turbulence and storms,but only "Normal" conditions.Mandelbrot's point,like Keynes's ,was that such storms occur much more often than predicted by the normal distribution.
Fox brings into the open the anti-scientific nature of the economics profession in his discussion of the efficent markets hypothesis.There are no goodness of fit tests that support the claims that the statistical time series data on price changes is normally distributed.However,this did not matter:" The overwhelming majority of research in finance in those days was no longer concerned with the question of whether markets were efficient.One just assumed that they were and proceeded from there, "(p.182).
There is a severe typographical error on p.183 in the second paragraph.Bernanke,Krugman,Summers,et. al.,are the most prominent economists of the early twenty first century ,not the twentieth century.
A more important error occurs on p.319.The author incorrectly identifies Keynes's low interest rate policy recommendation for dealing with the business cycle ,from pp.321-327 of the General Theory(GT,1936), as the policy used by Greenspan from 1996-2006.Keynes's low interest rate policy includes a major second part-bank loans are not to be made to speculators and rentiers.The unsatisfied fringe of borrowers must consist of speculators and rentiers.Unfortunately,Greenspan made no effort to prevent loans from falling into the hands of borrowers who did not meet the most basic ,elementary creditworthiness standards.
In summary,Fox correctly calls into question the current foundation of neoclassical,mainstream economics ,from the Black-Scholes equation,Capital Asset Pricing Model (CAPM),rational expectations,efficient market hypothesis,and Subjective Expected Utility theory to the Ptolemaic economists attempt to add more epicycles(more normal distributions) through the use of the artificially constructed ARCH,GARCH,GARCH II,FIGARCH,etc., models created by Granger and Engle in an attempt to bypass Mandelbrot's major analytic results.All neoclassical economics is built on the assumption that the normal distribution fits the time series data best.There is no historical,statistical,or empirical evidence to support this claim.Mandelbrot has developed statistical tests that are useful in identifying when the danger signals will show up in the time series data concerning possible catastrophic results in financial markets that spread faster than a tsunami.
on March 19, 2012
The Myth of the Rational Market is a survey of financial economics over the last century. It is written in a style which attempts to put the reader in the place and time when theories were constructed and understand the background of the market when academic ideas were promoted. It covers pre depression era through the the subsequent mathematization of economics and then into the growth of behavioral finance. The account is both readable and informative and the reader comes out with a good sense of history and some sense of theory. For those interested in the history of economic thought, this is a readable and lively account.
The book starts out discussing the modern beginning of financial economics with Irving Fisher. It introduces in chronological order people who started using statistics and data mining to examine properties of asset pricing. The first instances of random walk properties of bonds are discussed with Macaulay (from macaulay duration). The book makes a quick transition to Markowitz who introduces portfolio theory as a natural outgrowth of expertise gained from mastering optimization under uncertainty in the second world war. Ideas from CAPM and efficient market theory are discussed in historical context and the momentum of academic belief in the approach. The book then starts to focus on practical reality and the interplay between academics and industry is discussed with analysis of mutual fund returns, the rights of shareholders being a stick to reduce agency problems and in a certain sense it is a discussion of how aggregate behaviour can be seen to enforce the efficient market. As the book follows history in its actual sequence of events, with the 70s being a period in which markets performed abnormally to a certain extent, financial scholars began to question their assumptions and market failure is considered by many top academics. One can sense the growing disagreement in academic finance. The book continues into the modern financial era and discusses the change of belief of many of the efficient markets biggest proponents. Strong evidence is shown to allow for statistical anomolies in financial prices over time that dispute the efficient market convincingly. At the same time, mistakes of the past are rarely the mistakes of the future and so mispricings are not persistent. In addition examples of where mispricings lasted for longer than holders could hold are examined, in particular LTCM is discussed.
The Myth of the Rational Market is a nice historical account of academic thought on financial economics and the assumptions of academics about financial markets. Through historical account the reader sees the evolution of thought and the reasoning behind both the formation and subsequent changes in beliefs. It is both readable and informative and through the account the author basically argues that today people belief that markets might not be efficient, but there is no arbitrage. I recommend it as a colorful history of modern financial economics.
on February 27, 2011
"It leaves us with a need to find ways to temper speculative excess while acknowledging that we won't necessarily be able to distinguish speculative excess from a sustainable boom."
I bought "Myth of the Rational Market" to explore what causes economic cycles. This book is an interesting review of the theories that try to explain stock values and the factors that influence their price during rational times and investigates irrational times as well.
The more you know, the more you discover how little you know. This is true for this book. The author has done a great job of compiling this not-so-random walk down memory lane of Wall Street. I read this book twice, once in hard cover then again in Kindle to make notes on all the questions I had the first time I read the book. I could read it a third time to follow-up on all of the references but this will wait until my retirement.
This book reviews the history of human efforts to quantify human decision making in the financial market place. These efforts persist given the irrational episodes that the financial world experiences. Milton Friedman makes this comment on theories: "The relevant question to ask about the "assumptions" of a theory is not whether they are descriptively "realistic" for they never are, but whether they are sufficiently good approximations for the purpose in hand". The qualifying phrase in this statement is "sufficiently good" and the purpose that the theory serves. The relevant question for those owning stocks is, "Will my understanding of stock values leave me with enough wealth to retire?" Theories are supposed to capture what is predictable a majority of the time. Some theories are better than others. For the layperson this is of little comfort when your retirement funds disappear at a time when you will need them to be their maximum value.
This book is a great history of the development of the modern theory of stock prices. I highly recommend this book.
on August 30, 2009
This is a very well researched book. It is a review of all the key players in finance, economics and investing over the past century. The problem is that there is no central point contrary to the book's title. The organization is poor and at times I was frustrated following the book. There were numerous points when I would get very interested in something the author was writing but unfortunately all too often Mr. Fox would move onto a new topic or a new player. If you start skimming the book you will soon find out what I mean.
I have studied economics and have read a lot on similar topics. I was able to follow the author's points but without the appropriate background many readers may get bored or simply not appreciate the facts that the author presents in the book. It is not that the concepts are difficult; it is just that the significance of many parts may not be appreciated without appropriate context. On the positive side, readers will get an overview and summary of many important individuals such as Fisher, Keynes, Buffett, Samuelson and Shiller. I wish it had a more cohesive theme.