In pursuit of a myth

The Myth of the Rational Market – A History of Risk, Reward and Delusion on Wall Street, by Justin Fox

Markets are inefficient in pricing and pundits who propounded the efficient market hypothesis were unrealistic in their assumptions. This is the theme of a tidily-written tome by Justin Fox, the editorial director of the Harvard Business Review Group and a columnist for Time magazine. With investors still grappling with effects of a delusion that lasted 50 years, the book’s timing could hardly be better.

Fox’s treatment, without quoting a single mathematical equation, of such widely-followed theories as capital asset pricing is what makes the book appealing to experts and non-practitioners alike. For too long, academia had assumed that, since financial markets were liquid, pricing reflects the real economy. This was based on the belief that financial markets were more liquid and prices not as ‘sticky’ as those in which real goods were traded. Why then are there bubbles in financial markets and not in markets in real goods such as babies’ nappies? Because financial markets have a tendency to ‘herd’, something which is rare in markets dealing in goods.

The author illustrates his point with a canny example. If there is a $20 bill lying on the ground, then the supporter of the efficient market hypothesis would say: “If it were a real $20 bill, then somebody would have picked it up already.” In other words, in efficient markets prices at any given point capture all the information that investors need to know about security. Even when $20 bills are left lying around, over time the pricing discrepancy is arbitraged away. How did such a myth continue for such long? One reason, says Fox, is that, since the mid-1970s, the efficient markets theory has been an integral part of the way America’s pensions industry has been regulated.

Overall, this is a dense but fascinating narrative of financial history, featuring, in brief, the work of scholars such as Friedman, Markowitz, Miller, Modigliani, Sharpe and Shiller. It does much to dispel the myth surrounding financial markets. And not before time.