Chronicling the rise and fall of the efficient market theory and the century-long making of the modern financial industry, Justin Fox's The Myth of the Rational Market is as much an intellectual whodunit as a cultural history of the perils and possibilities of risk. The book brings to life the people and ideas that forged modern finance and investing, from the formative days of Wall Street through the Great Depression and into the financial calamity of today. It's a tale that features 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. It's also a tale of Wall Street's evolution, the power of the market to generate wealth and wreak havoc, and free market capitalism's war with itself.
The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth. It has been the maker and loser of fortunes, the driver of trillions of dollars, the inspiration for index funds and vast new derivatives markets, and the guidepost for thousands of careers. The theory holds that the market is always right, and that the decisions of millions of rational investors, all acting on information to outsmart one another, always provide the best judge of a stock's value. That myth is crumbling.
Celebrated journalist and columnist Fox introduces a new wave of economists and scholars who no longer teach that investors are rational or that the markets are always right. Many of them now agree with Yale professor Robert Shiller that the efficient markets theory “represents one of the most remarkable errors in the history of economic thought.” Today the theory has given way to counterintuitive hypotheses about human behavior, psychological models of decision making, and the irrationality of the markets. Investors overreact, underreact, and make irrational decisions based on imperfect data. In his landmark treatment of the history of the world's markets, Fox uncovers the new ideas that may come to drive the market in the century ahead.
Justin Fox has a great blog and writes for Time magazine, having previously written for Fortune magazine. So it was not a surprise that his book is well written and fast paced. Better yet, he has chosen to cover the most critical topic in all of finance: does the market correctly price stocks, bonds and real estates? In delivering a masterpiece he has either killed himself in thoroughly researching the subject or someone talented has directed him to all the right issues. He correctly dates the emergence of the efficient markets theory to the early twentieth century, then covers the contribution of Paul Samuelson, who is oddly enough always forgotten in any coverage about the efficient markets doctrine. He then goes through the sequence of Markowitz, Miller, Modigliani, Fama and Michael Jensen (an odd insertion indeed, since Jensen sweared by efficient markets theories but made his name emphasizing firm level inefficiencies, ones profitably eliminated by buyout funds, but whose profits would not be so impressive if the market could correctly price their coming contribution). He then introduces Richard Thaler and Robert Shiller, and thus downplays Amos Twersky and Daniel Kahneman, which is a failing of the book.
All in all it is a competent masterful history of financial theory and is a must buy for anyone with interest in investing. What it does not pretend to do is give readers a better idea of how to tackle market decisions. That is fine. What is not fine though, and what should be fixed in any future edition, is the lack of hard evidence on why markets are inefficient. There has to be a chapter on Warren Buffet and Peter Lynch and George Soros too, who made mince meat of efficient markets theories with the money they made. The point cannot be made from quotations of famous people alone. Had Justin Fox done that, he would have created a more complete book, what could even have been a classic. Also missing is the destruction derivatives have caused, and which are the offshoot of efficiency dogma. Once again Justin Fox tries to get off by a quotation here or there, but it is insufficient.
