Review: Myth of the Rational Market
I’ve long had the opinion that the financial markets are far from rational, and that the media, companies & market participants themselves dealing with them as rational – and, worse, rationalizing every strange market movement – is nothing short of insane. I haven’t had much fact-based research to back this opinion up, however, which is why I was interested in reading Justin Fox’s The Myth of the Rational Market: A history of risk, reward, and delusion on Wall Street.
The title tells quite succinctly what the book is about – it chronicles the creation and dismantling of the rational market theory from the very beginning. While reading up on the history of financial theories and how they were created was interesting and certainly useful per se it, to me personally, made for somewhat boring reading for the first 150 pages or so. Despite not exactly being a gripping page-turner, the first half of the book does provide a fascinating quick history of capitalism, the evolving view on profit & risk and, among other things, how the now-ubiquitous “shareholder value” came to mean anything.
One interesting aspect that I hadn’t fully digested earlier was that despite the view otherwise, one cannot really get paid for taking a risk, because risk is a measurable quantity that could be insured against; profit came when you proceed in the face of uncertainty. It may sound like a trivial difference, but the implications run deep.
During the course of reading the book, a few things become abundantly clear and with plenty of evidence to back the claims up. First, the markets are not rational or efficient. While this shouldn’t really come as a shock to anyone, for some reason the vast majority of (surprise!) finance professionals still act as if it is. The problem with utilizing this knowledge? No one person is rational either, so good luck in trying to beat the market. Second, the remarkably – for the lack of a better word – strange world of analysts, with all the expectations to beat the estimates and the resulting whisper estimates, “The Number” etc is revealed. Third, practically no actively investing funds does any better than the market on average – a find which any analyst, who supposedly trust mathematics, should find somewhat disturbing; already back in the 60s:
The scholarly consensus that nobody on Wall Street knew what he was doing began to harden. “Many academics have concluded that the value of investment advice is virtually zero,” Burton Malkiel and a Princeton colleague wrote in 1968.
Probably the most interesting part of the book is the anatomy of several market crashes and how they came to be. What’s most amazing are the rationalizations that some offer to explain the quirks and crashes away in order to keep holding on to the fatally wounded theories; this is from a chapter dealing with the 1987 crash:
“The appropriate response to the October performance of the market is applause“, Gene Fama declared. Fama’s reasoning was that an inefficient market would have been one in which the price decline occurred slowly. The rapid adjustment (a.k.a. crash) was evidence of how quickly the market processed new information. Left unanswered was what exactly that new information was. If your belief in efficient markets was strong enough, you didn’t need to know. The omniscient market had been able to sense something that, even after the fact, individual scholars and investors were unable to pin down.
At the end, some sobering conclusions are drawn. While fixing the market is probably too big a task to accomplish in short order, there is something companies can do, and something society needs to ponder:
It means that managers of a publicly traded company should insulate themselves and their employees from day-to-day or even month-to-month stock price fluctuations.
[..]
The biggest and hardest questions have to do with what sort of role we as a society give financial markets. For the past three decades the answer, backed by the theories of the rational market, has been to give markets an ever larger role – shoving aside other institutions such as governments and corporations. Now, though, we seem to have arrived at a turning point. It’s not just that the rational market theories have fallen apart. Financial markets have fallen apart, too.
All in all a very useful and interesting book that provides a lot of history and background to the nature of the market and how it works. Like I said, I found the first part somewhat boring reading, but overall the book was excellent. I would’ve hoped for some more coverage on the GFC, but then again the GFC as a tool against the rational market theory is a bit like shooting fish in a barrel so that might’ve been too easy..
The Myth of the Rational Market also gives a good background to many familiar names and as such provides much better context for understanding where Greenspan, Samuelson, Summers, Buffett, Minsky, Keynes, et al come from and what they’re all about.
Oh, and did I get the proof I was looking for that markets indeed are not rational? Yes. But, notably, I also learned that they’re not completely insane either and there actually can be some useful information embedded in the market figures.
The Brain Rules by John Medina has long been on my reading list and I finally got around to it. The book is constructed around 12 “brain rules”, each of which covers some aspects of the brain we know for sure. The we know for sure-part is important, because there is no shortage of books that speculate on what the brain does and how it does it, whereas all the “rules” in this book are backed up by numerous scientific studies. Perhaps surprisingly we don’t know much about the brain, but even more surprising is that what we do know is not being taken seriously. 



The world of high tech is filled with tales of spectacular failure and sheer stupidity; it is some of these tales that In Search of Stupidity – Over 20 years of high-tech marketing disasters (2nd edition) by Merrill (Rick) Chapman chronicles. While hindsight is always 20:20, Chapman argues convincingly that most if not all of the disasters could have been avoided, given just a modicum of common sense and situational awareness at the time. Better decision making might not have been enough to completely turn the fortunes but most of the idiocy could have been avoided. Having said that, In Search of Stupidity makes for very entertaining reading precisely because many companies did act so idiotically. 







