I just finished reading The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Streetby Justin Fox, and wanted to share some of my thoughts.
The book begins with the story of Irving Fisher and his attempt to apply mathematics in developing a theory for investment in the stock market and journeys through the history of the development of the rational market theory (a.k.a. rational choice theory, efficient market theory, etc). Fisher’s mathematical approach is placed in contrast with Charles Dow‘s technical analysis and Roger Babson’s trend-lines, both of which incorporate the emotive element of market participants as key elements in predicting future prices.
Running throughout the book is the underlying tension between those who take a mathematical approach to finance, investment and economics and those who add the behaviorist element to the discipline. Although the title suggests otherwise, Fox does not proceed to debunk the rational choice theory in a step-by-step manner. Rather, he tracks the history and development of the theory from its originals as an investment thesis through its transition into a macroeconomic philosophy. Much of the book is spent defining the theoretical underpinnings of the “efficient market theory,” a term first coined by Eugene Fama and the “random walk” theory of equity pricing.
In his historical account, Fox incorporates the theoretical contributions of those who sought out flaws in the rational market theory–people like Daniel Kahneman, Robert Schiller and Joseph Stiglitz–and emphasizes the fact that even these opponents of the rational market theory begin their analysis with the efficacy of the theory to an extent, in refuting the broader-based application of its specific precepts. The narrative is tied up with a reflective take on the rational market theory from Fama and an analysis of the broader theory in the wake of the financial crisis.
For my readers, I am sure you know that I am particularly fond of Hyman Minsky and his theories with regard to the financialization of the economy and the influence of the cyclicality in leverage on business cycles. I was pleased to see that Fox found Minsky to be a poignant and relevant figure in light of current events and an influential in his reapplication of Keynes’ “animal spirits” to modern financial theory. Interestingly, Fox cited John Mills (not to be confused with John Stuart Mills), who wrote “Credit Cycles and the Origin of Commercial Panics” in Manchester, England in the 1860s as the first to identify leverage cycles as a force behind the business cycle.
To investors, Fox’s narrative offers some important lessons: mainly the idea that price history is far more analogous to Brownian Motion (i.e. chaos) than it is to something rational. The two “technical” strategies proven to work best over time have been momentum and relative strength. For those who believe in backtesting, this is an important observation. Momentum and relative strength are the only two to have statistical merit. Perhaps most importantly, the fact that pricing is so emotional and chaotic provides an advantage to those who can identify a value and invest only in those times in which prices become dislocated from reality, thus offering value investors an opportunity profit.
For those interested in economics and investment, the book is an intellectual thriller which weaves a subtle conclusion through an intriguing historical narrative. As with many thrillers, Fox includes a Cast of Characters in the end which gives a brief account of each person’s contributions to the central plot–the creation or refuting of the rational market theory–and offers readers an easy reference through which to refresh on who is who along the way.
The conclusion succinctly ties up the key themes that play out over time and also leaves the reader with some intriguing questions to contemplate about our financial markets moving forward. All in all this is a great book for who like thinking about how and why to invest and what factors influence broader economic cycles and a must read for anyone interested in investment and/or economics.
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