3. The myth of the rational market.
Are markets rational (or “efficient” as one school of thought puts it) or aren’t they? That is a fundamental question for investors, with implications for just about every part of how best to structure an investment program.
My own view: anyone working in institutional investment who gives an unqualified “yes” to that question needs their head examined. The case can, however, be made for a qualified “yes”: markets are—most of the time—fairly rational, and it is appropriate—much of the time—to act as if they are rational. But, people being people (and, in particular, academics being academics) the middle position gets little attention: the seemingly reasonable stance that concepts such as modern portfolio theory and the efficient markets hypothesis can be a useful framework for addressing certain questions, even though they fall short (sometimes a long way short) of being a complete description of market behavior.
The case for that position is nicely built by Justin Fox in this 2009 book, which sets out a history of development of the theory around the rationality of market behavior. It’s the story of many of the names who have made the institutional investment world what it is today: Irving Fisher, Harry Markowitz, Eugene Fama, Jack Bogle, Michael Jensen, Dick Thaler, Bob Shiller and Alan Greenspan. This is not a technical book but, while Fox is a journalist rather than an academic or an investment practitioner, there’s plenty of investment meat.
Fox tries not to take sides… At least, not on the question of the rationality of markets. It’s a question of what you are using a theory—a model— for. He quotes Fischer Black who, on moving from the Massachusetts Institute of Technology to Goldman Sachs, observed to Peter Bernstein: “markets look a lot less efficient from the banks of the Hudson than the banks of the Charles.”
So the real lesson to be learned is perhaps summarized best in the afterword to the 2011 paperback version: “As supplements to individual judgment, and as checks on it, many of these new rules and tools of finance have turned out to be quite helpful. But as substitutes they bring disaster. They replace diversity and thought with mindless conformism.” Which I think is just a polite way of saying you need your head examined if you think markets are completely rational.
Justin Fox (2009). The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. HarperCollins.