The Myth of the Rational Market

The mathematics discussed in the book is not terribly complicated but the reader is given no formulas, no graphs, no applications of the quantitative theories. Yes, everyone knows what normal distribution looks like but the power laws discussed deserve a chart. Mandelbrot’s fractal theories need a diagram. Fox would also support his argument more strongly if he included the formulas which were eventually altered by the behavioralists. Without these, the reader is forced to blindly trust what Fox is telling him.

Despite these minor criticisms, the book is definitely worth reading. I am guessing that the title attracts many readers who hope financial-economics moves beyond the Chicago School efficient-markets framework. If this is what readers want, I recommend Beinhocker’s “The Origin of Wealth.” If you want a quick tour of academic financial thought, read Fox.

Saying that people are irrational and the market is irrational is of course now all the rage. But, if you think you can romp your way to financial security by taming your animal spirits and feeding off the market’s irrationality, I assure you, and Justin Fox assures you, that such is not the case. “While behaviorists and other critics have poked a lot of holes in the edifice of rational market finance, they haven’t been willing to abandon that edifice.” (p. 301). The reason is that the edifice is usually correct, although it can experience spectacular failures. The problem is that we don’t know when it will experience these failures. We do know, or at least I strongly believe, that the failures are due to herd behavior of investors, which undermines the applicability of the normal statistical distribution, the mainstay of traditional financial theory.

The theory that financial markets are rational is called the Efficient Markets theory. It has two parts. The first is that unless the investor has some inside information not available to other investors, he cannot tell if stock prices are too low, too high, or just right. This means that on average you can’t gain by using a general theory that says when stocks are over- or under-valued. The evidence in favor of this theory is overwhelming. If your stockbroker tells you he can pick winners, run as fast as you can. Indeed, the best policy is simply to invest in low-overhead mutual funds, and look VERY closely at the overhead. You’ll do very well that way over the long haul. Trust me.