Aurora Borealis
8 September 2017 Financial Analysts Journal Book Review

The Myth of the Rational Market (a review)

  1. Ronald L. Moy
The Myth of the Rational Market offers an entertaining and in-depth look at the modern history of the financial markets. This book is a great resource for anyone who would like to understand the efficient market/behavioral finance debate.

The recent passing of money manager and author Peter Bernstein reminds us that great storytelling can bring to life seemingly mundane and difficult topics. On the back cover of Justin Fox’s  The Myth of the Rational Market , Bernstein writes:

This wise and witty book is must reading for anyone who wonders what makes financial markets tick. Even those who have wrestled with this question for years will be glad to have read Fox’s compelling history.

That Bernstein, the author of  Capital Ideas  and  Against the Gods: The Remarkable Story of Risk , should provide one of the testimonials is appropriate because Fox’s excellent book may remind the reader of Bernstein’s writings. Bernstein was perhaps the first great storyteller of financial history, and Fox has done an outstanding job of following in that tradition.

Authors who undertake this type of academic project generally have backgrounds as either financial journalists or university professors. On the one hand, professors bring their considerable breadth and depth of knowledge to a project but often lack the ability to capture the reader’s imagination. Exceptions exist, most notably Columbia University economics professor Perry Mehrling’s superb and highly entertaining biography of Fischer Black and Emanuel Derman’s autobiography,  My Life as a Quant . On the other hand, journalists have the gift of storytelling but usually lack sufficient depth of understanding to provide a complete history of the topic. A blending of the two often produces the best results, as is the case with the best-selling book  Freakonomics  by economist Steven Levitt and journalist Stephen Dubner.

In  The Myth of the Rational Market , Justin Fox, the business and economics columnist for  Time magazine, overcomes the usual weakness of most financial journalists and offers an entertaining and in-depth look at the modern history of the financial markets. Fox has clearly spent countless hours reading journal articles and interviewing academics who have shaped the theory that the market is rational, as well as those who have criticized that belief. Given Fox’s expert handling of the material, that he has not spent at least a portion of his career in academia is hard to believe.

Perusing this book will likely provide many readers with the  déjà vu  experience of studying finance in graduate school. Much of the book discusses the theories of Harry Markowitz, William Sharpe, Eugene Fama, and Richard Thaler. The beauty of the experience is that Fox’s explanations of these luminaries’ theories are not burdened by mathematical equations that sometimes prevent the reader from seeing the ingeniousness of the ideas.

Those who have seriously studied finance are likely to enjoy the way the author uses entertaining stories about prominent financial economists to fill gaps in understanding how their theories came to fruition.  The Myth of the Rational Market  shares a characteristic with Sylvia Nasar’s best-selling biography of John Nash,  A Beautiful Mind— namely, that a book is more engaging when the reader is familiar with the players. Because Fox is writing for members of the general business community, who may not be acquainted with all the pioneers of modern finance theory, he has wisely included short profiles of the key players, from Kenneth Arrow to Holbrook Working.

Fox has done an amazingly thorough job of piecing together the history of the efficient market debate. One might expect that a book devoted to rational markets would begin with Fama and the 1960s, but Fox starts his discussion with Irving Fisher (1867−1947) and Louis Bachelier (1870−1946). Although the efficient market debate took off with the work of Fama, its origins began much earlier, when such researchers as Fisher, Bachelier, and Working (1895−1985) first recognized the randomness of stock price movements. A formal basis for market efficiency began with the theoretical work of Markowitz and Sharpe and their models of market equilibrium.

Similarly, the challenge to the rational market debate took decades to gain acceptance. Herbert Simon started the thinking that markets may not be rational when he theorized that individuals do not optimize but rather choose to  satisfice . Some two decades later, psychologists Amos Tversky and Daniel Kahneman began the revolution against rational markets by showing, through numerous experiments, that individuals do not always behave rationally. The debate was later joined by Thaler, Robert Shiller, Lawrence Summers, and Andrei Shleifer. Today, evidence in support of the behavioral school continues to grow with the work of a new wave of behavioralists, such as Meir Statman, Hersh Shefrin, Terrance Odean, and Brad Barber.

What sets this book apart is the level of detail and the stories that link the pioneers of finance together. The cast of characters includes not only the leaders of the efficient market school and the behavioral finance advocates, such as Fama, Tversky, Kahneman, Thaler, Merton Miller, and Michael Jensen, but also noted economists who are less well known for their contributions to finance, such as Paul Samuelson, Hendrik Houthakker, and Joseph Schumpeter.

Books written by financial journalists usually receive scant attention from academics. Fox’s book, however, should be required reading for new MBAs and PhD’s in finance. Young professors and future business leaders will probably not gain any additional understanding of the theoretical aspects of the book’s topics that they could not receive from reading the original papers, but they will probably obtain the key insight missing from most journal articles: the “aha” moment that led many of these researchers to their seminal ideas. Publishing in top-tier journals requires the use of powerful mathematics and econometrics. Pathbreaking research and new business paradigms, however, require keeping an open mind to new ideas that will change the thinking of a profession.

Some of Fox’s stories may be familiar to readers—for example, Harry Markowitz’s conversation with a stockbroker who was sitting outside the office of Markowitz’s dissertation adviser. Other stories are not as well known, such as the circumstances under which John Lintner became a reluctant contributor to the capital asset pricing model. Another less widely known tale relates how Thaler, who studied and taught at a bastion of the rational market school (the University of Rochester), became a leader of the behavioral school.

Beginning with his discussion of the academic literature and culminating in the book’s final chapter, “The Anatomy of a Financial Crisis,” Fox makes a compelling argument against rational markets. Numerous supporters of the efficient market hypothesis have made it more difficult to refute by arguing that market efficiency does not require everyone to be rational but simply requires enough smart players to arbitrage prices to their appropriate level. The recent bursting of the housing bubble and the financial crisis of 2008−2009, however, seem to indicate that the market may, in fact, not be rational.

Those who have read Bernstein’s classic  Capital Ideas  and its sequel,  Capital Ideas Evolving , are likely to find Fox’s effort the capstone of an excellent trilogy on the history of modern finance. The Myth of the Rational Market  is a great resource for anyone who would like to understand the efficient market/behavioral finance debate. It is also one of the most readable and entertaining books on the topic that one is likely to find.


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