The Myth Of A Rational Market

Justin Fox, “The Myth of the Rational Market” (A History of Risk, Reward, and Delusion on Wall Street), Harper Collins, 2009,370 Pages

The efficient-market hypothesis has long maintained that markets are rational. On the other hand, a group of behaviorists have documented irrational behavior of investors and the many instances of market pricing errors. In "The Myth of the Rational Market," Justin Fox outlines the debate between these two schools of thought.

This book traces the history of financial ideas and the people behind them, principally the scholars in the field of financial investments, such as Paul Samuelson, Bill Sharpe, Harry Markowitz and Daniel Kahneman. Fox presents clear explanations of Portfolio Theory, the Capital Asset Pricing Model and Option Pricing Theory. As Mr. Fox states on

Pg. xv: “ This book offers no grand new theory of how markets truly behave. It is instead a history of the rise and fall of the old theory—the rational market theory. It is a history of ideas, not a biography, or even a collection of biographies. But it is full of characters—most of them economists and finance professors—who were actors in many of the great dramas of the twentieth century, from the 1920s boom to the 1930s Depression to war and then peace and prosperity, then 1960s boom and 1970s bust and so on.”

Mr. Fox recounts the battles between the early "random walkers" (those who do not believe that you can predict a stock price by referring to trends or past behavior) and "chart followers" (those who do). Most importantly he portrays how the efficient-market theory is now supplemented, not replaced, with behaviorist’s ideas. No-one, it seems, believes totally in the efficient market anymore but so many financial analysis tools are dependent on it that it cannot just be dropped. It still is a good tool—most of the time, not always.

Also, Mr. Fox himself notes that both behaviorists and supporters of market efficiency believe that low-cost index funds should constitute the core of every investment portfolio. Both groups realize that it is dangerous to bet that you know more than the market. Even legendary investor Warren Buffett believes that most investors would be better off if they invested in index funds. I allocate 75% of my investment funds to index funds and use only the remaining 25% for individual stocks I personally pick.

My Notes:

Pg. xiii: The notion that financial markets know a lot has been around as long as financial markets themselves. In 1889, stock market chronicler George Gibson asserted that when “shares become publicly known in an open market, the value which they there acquire may be regarded as the judgment of the best intelligence concerning them.” Even St. Thomas Aquinas held that the just price was set by the market.

Pg. xiv: The twentieth-century version of rational market theory started with the observation that the movements of stock prices were random, and could not be predicted on the basis of past movements. This observation was followed by the claim that it was impossible to predict stock prices on the basis of any publicly available information (such as earnings, balance sheet data, and articles in the newspaper). From those starting points flowed the conviction that stock prices were in some fundamental sense right.

Pg. 132: If stock price movements obeyed the normal distribution, all sorts of useful conclusions could be drawn. Harry Markowitz’s equations for balancing risk and reward depended on stock price movements sticking to a bell curve. So did the investment-performance measures devised by Bill Sharpe, Mike Jensen, and Jack Treynor. The only problem was that actual stock prices don’t always follow a random walk. They do much of the time—but not all of the time. Sometimes they plunge, as did the Dow Jones on October 28, 1929. The Dow usually moves in one-day increments of less than 1 percent. That day it dropped 13.5 percent, the next 11.7 percent. On October 30, it rose 12.3 percent.

In statistical terms these rare but significant events are called fat tails, because they are found at the tail ends of a statistical distribution and keep them from converging quickly with zero—as they would in a true bell curve. The tendency of fat-tail events to follow upon one another is called dependence.

Pg. 133: IBM mathematician Benoit Mandelbrot saw fat tails and dependence in a chart of cotton futures prices at Harvard in 1960. Patterns which allow far more room for outliers than the standard curve, had first been observed around the turn of the nineteenth century in the distribution of wealth, and it was the statistics of wealth and income that Mandelbrot studied. (I predict we will hear more about this type of curve in the future).

Pg. 137: In the wake of several corporate bankruptcies that left pensions unpaid, Congress passed pension-reform legislation in 1974. The Employee Retirement Security Act has since gone on to have many interesting consequences. The first had to do with the standard of prudence laid down by the law and in subsequent regulations. No longer a legal concept based on tradition, prudence was redefined to mean following the scientific dictates of modern portfolio theory.
In this accounting, risk ceased to be a vague, unquantifiable menace that could be tamed only with judgment. It was a number, variance, which would be estimated mainly by looking at past variance. This development was in one way curious: The same finance scholars who claimed that you could not predict future stock price movements by looking at past stock price movements were embracing the idea that future stock volatility could be predicted by looking at past stock volatility.

Pg. 223: The difference between the worldview of Buffett and Thorp and that of rational market finance was chiefly of time frame. The finance guys thought markets got things right immediately. The Buffett believed it could take a while.

Pg. 228: Without estimating what could go wrong (and, if possible, insuring against it), one cannot begin to make the long-term investments that undergird economic growth. Without quantification of risk, modern capitalism would be unimaginable. Quantifying risk in financial markets, though, is far more complicated than estimating the likelihood of fire or burglary or death. Financial markets are not natural phenomena. They are man-made—made by men and women whose business is grazing into an uncertain, risky future. The act of managing risk in such an environment alters that environment, creating a never-stable feedback loop. The crash of 1987 was the first alarming demonstration of the inherent instability of mathematical risk-management models in finance. It was not to be the last.

Pg. 236: While portfolio insurance proper had been largely discredited in 1987, the market for insuring against the vagaries of the market never went away. Before long, the big banks and investment banks were using options-pricing models to design and price private contracts called over-the-counter derivatives that enabled clients to hedge against (or bet on) financial risks. Now these instruments cover stock market moves and loan defaults, among other things but in the first years after the crash of 1987 the two main categories were interest-rate and currency derivatives.

Pg. 301: Wile Behaviorists and other critics have poked a lot of holes in the edifice of rational market finance, they have not been willing to abandon that edifice. They have not been willing to dispense with the equilibrium framework that Irving Fisher imposed on the field a century before. They spend their days studying disturbances and biases, but they still trust that Merton Miller’s “pervasive forces” are out there somewhere, pushing prices at least in the general direction of where they belong.

Pg. 311: The standard neoclassical theories simply ignored the business cycle. The mainstream economists such as Irving Fisher and John Maynard Keynes who explored economic downturns tended to portray them more as fixable divergences from the economic norm than as phenomena intrinsic to capitalism. It is apparent, though, that something important is lost when Mills’s observation about fluctuating attitude toward risk is removed from the analysis of the market. Keynes tried to incorporate it with talk of “animal spirits” that affected economic activity, but the Keynesian economics that arose in his wake busied itself with more mechanistic, less psychological explanations for downturns.

Pg. 312: Ponzi finance, in Minsky’s taxonomy, involved making loans that could not be paid off out of the anticipated income of the borrower. Only if the price of the asset against which the loan was made kept going up would things turn out well. Just like the pyramid schemes of the turn of the early twentieth century Boston fraudster Charles Ponzi, this kind of thing by definition has to end badly. In 2003 or so, Ponzi finance came to dominate the U.S. housing industry. It ended badly.

Pg. 313: The slicing and packaging of mortgages into debt securities—which first became common in the 1980s, thanks in part to option-based mathematical models that made it easy to price them—was only applied to high-quality, conventional mortgages. This market was dominated by two government-created giants, Fannie Mae and Freddie Mac. Late in 2003, Fannie and Freddie pulled back, stung by accounting scandals and barred from buying most subprime mortgages or any loans bigger than the conforming loan limit set by regulators--$322,700 in 2003. Wall Street firms eagerly filled the void. They bought the mortgages from brokers and other mortgage lenders and packaged them into mortgage-backed securities. Perversely, Fannie and Freddie were allowed to buy these, and acquired tens of billions of dollars in subprime-mortgage-backed securities to met affordable housing goals set by Congress.

Pg. 320: The efficient market hypothesis, the capital asset pricing model, the Black-Scholes option-pricing model, and all the other major elements of modern rationalist finance rose toward the end of a long era of market stability characterized by tight government regulation and the long memories of those who had survived the Depression.. These theories’ heavy reliance on calmly rational markets was to some extent the artifact of a regulated, relatively conservative financial era—and it paved the way for deregulation and wild exuberance. Now we seem to be headed in reverse.