 The Myth of the Rational
Market
By
Justin Fox
A
book review by Richard Gill of the AIM & PLUS Newsletter
The Myth of the Rational
Market costs GBP 18.99 in the Square
Mile Bookstore and can be bought by clicking
here
In
the Myth of the Rational Market author Justin
Fox, the business and economics columnist for
Time magazine, explains why one of
the most popular financial theories of the
late 20th century is, as Yale professor
Robert Shiller puts it "...one of the most
remarkable errors in the history of economic
thought".
The theory that stock (and other financial)
markets are rational is known as efficient
markets theory. To put it simply the theory
states that unless acting on inside
information i.e. information which others do
not have, investors will not be able to
consistently outperform the market, except by
chance. The argument is that the market,
which is the sum of knowledge of all
investors, is always right, and the combined
knowledge always provides the best judge of
the value of an asset.
While the academic evidence for the theory is
claimed to be supportive, the theory is
clearly nonsense. Would Warren Buffet,
Anthony Bolton, Benjamin Graham, Peter Lynch
et al have made their fortunes if the theory
held true? Conversely, if the theory was
correct then Nicola Horlick wouldn't 't have
done half as badly.
The theory also suggests that mis-pricings in
the market can not last for very long. As
soon as investors find an under/over valued
stock they will react accordingly and change
the price as soon as they can, according to
the theory. This is also nonsense - take the
dot.com boom at the start of the
century or indeed any financial bubble and
you will see that investors regularly
over-price (and under-price) shares for long
periods of time.
In the book Fox takes us through a history of
how science tried to come up with an
explanation of how financial market works.
From the writings of economist Irving Fisher
in 1905 we are taken through the development
of the efficient market theory at the
University of Chicago in the 1960s, its
effect on the stock market and present day
thinking.
In general the book is easy to understand,
with Fox's talent as an experienced financial
and economic journalist coming out. Sometimes
however, the language is a little too simple,
with more explanations required of the maths
behind the theories he discusses. Overall,
the book is an entertaining and informative
read which can be enjoyed by anyone from an
economics student to a private
investor.
The Myth of the Rational
Market costs GBP 18.99 in the Square
Mile Bookstore and can be bought by clicking
here
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