The myth of the rational market: Justin Fox

It is turning out to be a longish stretch of market related books for me. After Bogle and Galbraith, it is now the turn of Time columnist Justin Fox and his book on the efficient market hypothesis. I think I have had my fill and should move to other subjects for a little while.

The myth of a rational market is an exploration of the up and down history of the efficient market hypothesis around financial markets. The tagline of the book says 'A history of risk, reward, and delusion on Wall Street'. It is nothing of the sort. I am not sure why they chose that subtitle. It is really not what the book is about. And it is not like this is a particularly compelling or resonant title either. Strange are the rules of the publishing world.

Come to think of it, the title of the book is somewhat misleading as well. The myth of the rational market does not prove by any means that the rational market is indeed a myth. In fact, towards the end, Fox asks the question 'Where has the debate over market rationality ended up?' He goes on to answer himself with 'In something more than a draw and less than a resounding victory'. Not exactly the most compelling case for calling the rational market a myth.

For the record, I should state that I do indeed sympathize with Fox's broad view on the matter - that markets are broadly and mostly rational, but are not rational always and everywhere. Long time readers of Brick and Rope might remember my admiration for Dan Ariely's behavioral economics book Predictably Irrational. Human decision making is not entirely rational. And it isn't irrational in any random, unpredictable way. It is so in systematic, entirely predictable ways. Then there are the regularly occurring market crashes, boom and bust cycles and plain failures of the market (calling as witness #1: banks that are too big to fail). Finally there is the curious case of the Ben Graham disciples - a group of investors all studying under one master and going on to build the most extraordinary track records. The case for a perfectly rational market where all knowable information is reflect in prices does dim a little bit in light of these facts.

The myth of the rational market does have a particularly evocative passage about the last of the above - the inexplicably great performance of Warren Buffett and other Graham disciples over the last four decades. Michael Jensen, one of the most vocal proponents of the rational market approach once declared that there was 'no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis'. In May 1984, Jensen was invited to the Columbia Business School to debate with (among others) Warren Buffett on this view. He explained away the historical performance of Buffett and some others by invoking the much-used analogy of the serial coin-flipping game where everyone starts with a dollar to call a coin flip. Correct callers take the entire loot and call the next round, and so on. After 100 rounds, you would expect to find 215 millionaires. That doesn't make them superstars, goes the argument, just lucky. Buffett responds, with characteristic wit, that 'maybe the professors claim that coin-flipping orangutans would have achieved the same result ... but if you found that 40 of the 215 millionaires came from a particular zoo in Omaha, you could be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else.'

The passage is illustrative of both the strengths and weaknesses Justin Fox as an author of a book about the markets. It is interesting, witty, light and entirely accessible for the lay reader. It is just the kind of thing you would expect a journalist to come up with. But ultimately, the anecdote is just that. Not evidence. Just an anecdote. You get this feeling again and again in the book - that Fox is unable or unwilling to get into the detailed evidence for or against a proposition, but is happy to let an anecdote do the heavy lifting for him.

In his 'A note on sources' at the end, Fox writes - 'I am a journalist, not a scholar, and this is a work of journalism, not a Ph.D. dissertation.' True words. Believe him. For a deep understanding of the rise and fall (and rise and fall, and ...) of the Efficient Market Hypothesis, there are better places to go. But for a breezy, character packed, overview of this thoroughly interesting question about markets, you could do much worse than The myth of the rational market.