By Justin Fox
A lively history of ideas, The Myth of the Rational Market by former Time Magazine economics columnist Justin Fox, describes with insight and wit the rise and fall of the world’s most influential investing idea: the efficient markets theory. Both a New York Times bestseller and Notable Book of the Year — longlisted for the Financial Times Business Book of the Year Award and named one of Library Journal Best Business Books of the Year — The Myth of the Rational Market carries readers from the earliest days of Wall Street to the current financial crisis, debunking the long-held myth that the stock market is always right in the process while intelligently exploring the replacement theory of behavioral economics.
John Brock on International Review of Economics Education wrote:
"Justin Fox’s Myth of the Rational Market brilliantly tells the story of how that edifice [of the American financial system] was built — and why so few were willing to acknowledge that it was a house built on sand. [...] Instead of focusing on the errors and abuses of the bankers, Fox [...] tells the story of the professors who enabled those abuses under the banner of the financial theory known as the efficient-market hypothesis. Fox’s book is not an idle exercise in intellectual history, which makes it a must-read for anyone who wants to understand the mess we’re in. Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy. [...] One of the great things about Fox’s writing is that he brings to it a real understanding of the sociology of the academic world. Above all, he gets the way in which one’s career, reputation, even sense of self-worth can end up being defined by a particular intellectual approach, so that supporters of the approach start to resemble fervent political activists — or members of a cult. [...] In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process."
Matías Vernengo on Review of Political Economy wrote:
"The book is a masterfully documented and engaging history of the rise and the fall of the efficient market hypothesis (EMH). [...] From its earliest characterisation, the powerful and mathematically eloquent theory of EMH has developed into a broader set of conclusions. Fox describes how EMH progressed from the observation that stock price movements were random, to the claim that it was impossible to predict stock prices and, finally, to the conviction that ‘stock prices were in some fundamental sense right’ (p. xiv). [...] Economists as well as professional investors will find the Myth of the Rational Market an enjoyable, stimulating and worthwhile read. Undergraduate or graduate students, particularly business and economics majors enrolled in a History of Economic Thought or Personal Finance course, will take pleasure in reading this fascinating and very thoroughly documented story [...]. The beauty of the book is that Fox has integrated a great deal of economic and finance theory into a summary of the contributions by many of the key contributors of the past century. He not only discusses their academic contributions, he cleverly infuses interesting personal anecdotes along the way. [...] The Myth provides some worthwhile insights for students of economics. [...] While mathematics provides a very useful tool, it is no more powerful than the assumptions that form the basis for its application. In classroom instruction, economists use assumptions not because they are always accurate representations of reality, but because they help students grasp the underlying logic of a situation. However, in the real world of financial markets, invalid assumptions sometimes generate dramatic failures. [...] Without realising it, students will be immersed in a story that generates an appreciation and better understanding of the scientific method – another reason to adopt this book in a college economics or finance course. Mr. Fox goes beyond merely discussing the basic logic of the models by addressing the personal attachment that many of those involved (understandably) acquire toward the theories they were instrumental in developing. It is hard to change one’s position once a reputation and career have been built upon it."
"In his conclusion, he attempts to relate the behavioral critique to Keynes’s analysis and to Hyman Minsky’s theory of crises. However, his interpretation of Keynes and Minsky emphasizes their recognition of the psychological inaccuracy of models that assume rational behavior; the book says a lot about decision-making, but nothing about structures. Minsky, though, believed that competition would force firms to adopt financial structures that were increasingly unstable, and that this would occur even if agents were rational. In addition, the book pays no attention to what financial markets actually do; Fox presumes that all they do is allocate funds for investment, and try to evaluate risk. He does not even consider the possibility that the function of financial markets might not be to enable the efficient allocation of resources, but to operate principally as a device for promoting capital concentration and surplus extraction, and the fact that their very structure limits the ability of agents (even rational ones) to choose the most efficient alternative is not even considered. If one believes Fox’s story, bubbles are irrational and not particularly useful. Yet, the historical record seems to indicate that bubbles have consistently led to increased concentration of capital and facilitated the amplified reproduction of the economy (e.g. railroads were built and financed by bubbles). Modern finance theory has little to say about the issue, and so does this book."
The Rational Market and Other Financial Myths
A video of 5.5 minutes by Big Think in which "Justin Fox of Time Magazine explains the appeal and the downfall of the rational market theory and tells us the next great economic theories and investment models":
Alternatively, you may want to watch this 43 minute talk by Fox about the book at Google Headquarters.
Table of Contents of The Myth of the Rational Market
- Introduction: It Had Been Working So Exceptionally Well
- Irving Fisher Loses His Briefcase, and then His Fortune; The first serious try to impose reason and science upon the market comes in the early decades of the twentieth century. It doesn't work out so well.
- A Random Walk from Fred Macaulay to Holbrook Working; Statistics and mathematics begin to find their way into the economic mainstream in the 1930s, setting the stage for big changes to come.
The Rise of the Rational Market
- Harry Markowitz Brings Statistical Man to the Stock Market; The modern quantitive approach to investing is assembled out of equal parts poker strategy and World War II gunnery experience.
- A Random Walk from Paul Samuelson to Pail Samuelson; The proposition that stock movements are mostly unpredictable goes from intellectual curiosity to centerpiece of an academic movement.
- Modigliani and Miller Arrive at a Simplifying Assumption; Finance, the business school version of economics, is transformed from a field of empirical research and rules of thumb to one ruled by theory.
- Gene Fama Makes the Best Proposition in Economics; At the University of Chicago's Business School in the 1960s, the argument that the market is hard to outsmart grows into a conviction that it is perfect.
The Conquest of Wall Street
- Jack Bogle Takes on the Performance Cult (and Wins); The lesson that maybe it's not even worth trying to beat the market makes its circuitous way into the investment business.
- Fischer Black Chooses to Focus on the Probable; Finance scholars figure out some ways to measure and control risk. More important, they figure out how to get paid for doing so.
- Michael Jensen Gets Corporations to Obey the Market; The efficient market meets corporate America. Hostile takeovers and lots of talk about shareholder value ensue.
- Dick Thaler Gives Economic Man a Personality; Human nature begins to find its way back into economics in the 1970s, and economists being to study how markets sometimes fail.
- Bob Shiller Points out the Most Remarkable Error; Some troublemaking young economists demonstrate that convincing evidence for financial market rationality is sadly lacking.
- Beating the Market with Warren Buffett and Ed Thorp; Just because professional investors as a group can't reliably outperform the market doesn't mean that some professional investors can't.
- Allan Greenspan Stops a Random Plunge Down Wall Street; The crash of 1987 exposes big flaws in the rational finance view of risk. But a rescue by the Federal Reserve averts a full reexamination.
- Andrei Shleifer Moves beyond Rabbi Economics; The efficient market's critics triumph by showing why irrational market forces can sometimes be just as pervasive as the rational ones.
- Mike Jensen Changes His Mind about the Corporation; The argument that financial markets should always set the priorities - for corporations and for society - loses its most important champion.
- Gene Fama and Dick Thaler Knock Each Other Out; Where has the debate over market rationality ended up? In something more than a draw and less than a resounding victory.
- Epilogue: The Anatomy of a Financial Crisis
About Justin Fox
Justin Fox is a columnist for Bloomberg Opinion and a contributor to Bloomberg Businessweek. He was previously editorial director and executive editor of the Harvard Business Review. He is the author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. Before joining HBR, he wrote a column for Time and created the Curious Capitalist blog for Time.com, and before that he spent more than a decade writing for Fortune magazine. He was a senior fellow at Harvard Kennedy School and a Young Global Leader of the World Economic Forum.