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The Myth of the Rational Market

Financial markets were supposed to know better. They were supposed to be near-perfect processors of information and assessors of risk. They were supposed to be steering us toward a more prosperous, less economically volatile future. Then they failed, spectacularly. Justin Foxs The Myth of the Rational Market tells the story of how we came to believe that financial markets knew best, and how that belief steered us wrong. Chronicling the rise and fall of efficient market theory and its century-long role in the making of the modern financial industry, the book is both history and intellectual whodunit. It brings to life the people and ideas that forged modern finance and investing, from the Great Depression and into the financial calamity of today. Its a tale largely about professors, but professors who made and lost fortunes, battled fiercely over ideas, beat the house in blackjack, wrote bestselling books, and played major roles on the world stage. Its also a tale of Wall Streets evolution, the power of the market to generate wealth and wreak havoc, and free-market capitalisms recurrent war with itself.

The efficient market hypothesislong part of academic folklore but codified in the 1960s at the University of Chicagohas evolved into a powerful myth. It has been the driver of trillions of investing dollars, the

inspiration for index funds and vast new derivatives markets. In its strongest form, the theory holds that the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets. That belief has crumbled. The Myth of the Rational Market introduces a new wave of scholars who no longer teach that investors are rational or that markets are always right. Many now agree with Yale professor Robert Shiller that efficient market theory represents one of the most remarkable errors in the history of economic thought. Today the theory is giving way to new hypotheses of market behavior growing out of psychology, physics, evolutionary biologyand even traditional economics. In his landmark intellectual history, Fox uncovers the new ideas that may drive markets in the century ahead. A Myth of the Rational Market Q&A 1. What is the myth of the rational market?

Most simply, its the belief that financial markets can be relied upon to get things right. In the context of my book, it refers to the academic theory most commonly known as the efficient market hypothesisalthough I often refer to it as rational market theory because thats shorter and, for those of us who arent finance professors, clearer. 2. What is main takeaway of your book?

That financial markets possess many wonderful traits, but that rationality is not always among them. And that relying on markets to be right all the time can be a very dangerous thing to do. 3. Does your book explain the current financial crisis or any aspect of it?

Yes. Financial decision-making and financial regulation had been restructured over the past couple of decades around the notion that market prices are correct. If market prices and formulas built around market prices said one thing, the thinking went, then who was a Federal Reserve chairman or investment bank CEO to say they were wrong? It was a suspension of judgment on a mass scale, and it turned out really badly. 4. How is The Myth of Rational Market any different from other books on economic history? What is its unique appeal? I dont know of any other book that tells the story of the rise and fall of the idea that financial markets are always right. So thats unique. Beyond that, Ive tried really hard to make the book exhaustive without being exhausting. Its written for the lay reader, but also meant to withstand the scrutiny (I hope) of the academic reader. 5. What are some of the practical lessons of the book and do they have any application to economic recovery?

The most important practical lesson of the book in the context of the current economic situation is that financial markets dont know everything. They know a lot, and the signals they send shouldnt be completely ignored. But when the market decrees that a collateralized debt obligation is worth a certain amount, or that a trader at Lehman Brothers should be paid a certain amount, or that a speech by the Treasury Secretary is no good, it often gets things entirely backwards. Our society (and our financial markets) cannot survive and thrive if all decisions are left to the market. Oh, and one another practical lesson: Stocks are a much better long-run investment when theyre cheap by historical standards (as measured by price-to-earnings or price-to-book ratio) than when theyre expensive. 6. Although rational market theory was at first controversial, why did it become so widely accepted as standard practice? First of all, because the facts seemed to back it up. For example: Finance scholars argued in the mid-1960s that the superstar mutual fund managers of the day were beating the market only by taking crazy risks that would eventually backfire. Within a couple of years, most of those stars had flamed out. More broadly, rational market theory offered straightforward answerssome of them correctto a lot of questions that had long plagued investors, corporate managers and regulators. 7. In recent decades, you note the theory traveled beyond the stock market to apply to other securities and especially to what came to be known as derivatives. Do you think this played a major role in the current economic crisis? Yes it did. Although its not perfectly rational all the time, the stock market does process information quickly and handles even really bad news in a mostly orderly fashion. The same can usually be said for the organized exchanges in derivatives such as stock options and commodity futures. The off-exchange markets for mortgage securities and over-thecounter derivatives never developed the rules and contingency plans characteristic of well-established exchanges, yet were still expected to perform the same functions. When hit by adversity in the summer of 2007, many of these markets stopped functioning entirely. That, as much as anything else, was what turned a financial problem into a crisis. 8. What can todays investors learn from studying rational market theory?

The market isnt rational, but neither am I. Over the course of researching and writing this book, I actually moved more and more of my investment portfolio into index funds. It wasnt because I think nobody can beat the indexes, or that currently prevailing market prices are by definition right. But index funds charge the lowest fees, and Ive become increasingly dubious that in my spare time I can pick stocks or investment managers that will beat the market after fees.

For those with more time and perseverance than I possess, the big lesson from the fall of rational market theory is that value investing worksbut it works in large part because its very hard to stick to. 9. What do you see as the future of Wall Street?

Well have a long period of rethinking and relative sobriety, and then make all the same mistakes (or at least similar ones) again in 50 years or so. 10. How did you come upon the idea of writing this book? And, how did you conduct the research? The particular thing that got me started was encountering a book in 2002 by a finance professor, Peter Bossaerts of Caltech, that said the efficient market hypothesis had outlived its usefulness. What interested me was that Bossaerts sounded almost wistful about ithe wasnt an efficient-market critic, just a realist. I knew there was a debate about the efficient market. This was the first hint I got that it was more or less over. It led to a 2002 Fortune article titled Is the Market Rational? No, say the experts. But neither are you, so dont go thinking you can outsmart it. Which in turn led to a book contract, six months spent reading through old academic journals at the New York Public Library and Columbia Business School Library and interviewing economists and finance scholars across the country, then years of thinking, writing, and much more reading and interviewing. Oh, and lots of staring blankly at a computer screen.