The Myth of the Rational Market
In this morning’s NYT, Joe Nocera takes on one of my favorite subjects: Why the market is neither rational nor efficient.
He does a nice job, interviewing both Jeremy Grantham and Burton Malkiel. Along the way, he mentions Justin Fox’s new book, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.
Excerpt:
“In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.
These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday — damage that we’re still dealing with. How much damage? In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.
I prefer Res Ipsa Loquitur, but hey, its all Latin to me.
I am about halfway through The Myth of the Rational Market, and so far, its good wonky fun. (Justin, there’s your pull quote: good wonky fun“). When I’m finished, I will post a review, though I expect my experience in writing a book to have eliminated all objectivity when it comes to reviewing other books.
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Source:
Poking Holes in a Theory on Markets
JOE NOCERA
NYT, June 5, 2009
http://www.nytimes.com/2009/06/06/business/06nocera.html
June 6th, 2009 at 7:43 am
good wonky fun
a registered trademark of the Hasbro company
June 6th, 2009 at 8:09 am
If by ‘rational’, you mean ‘random’, then of course the markets are rational.
We always assume someone is in control — even when it’s obvious that we’ve driven off a cliff. The ‘efficient’ part doesn’t happen until we hit the ground.
June 6th, 2009 at 8:31 am
‘Justin, there’s your pull quote: good wonky fun’“
Did I just get called out? Somehow, I doubt I’m even remotely that important, but considering that you and I have had our disagreements over EMH (not whether or it’s 100% accurate, but whether or not its main conclusion – that it’s damn hard to beat the market in the long term net of transaction costs and taxes – holds true), it makes me wonder….
Now that I’ve got that out of the way, the idea that EMH is responsible for the current market crisis is, well, indefensible.
“Should we make these subprime NINJA loans that hoodwink the poor and middle class?” “Well, EMH says it’s all good, so let’s ROCK AND ROLL!!!!eleventy1!”
“If we don’t take on this shitty debt from GM we’re going to lose their cash and hedging business. Let’s create some toxic double-defaulting swaps.” “EMH is go; I repeat, EMH is go.”
Um, no.
June 6th, 2009 at 8:48 am
a perfectly engineered form of capitalism is the path to world peace and prosperity .. what a concept
… maybe 20 more generations from now .. we’ll see
June 6th, 2009 at 9:19 am
It all very simply to understand
1) Low rates interest rates, easy money, and the availability of excessive leverage makes someone salivate. All that money has to be put to use.
2) Through the invisible hand, the supply of funds find a place to go. Others want in, creating demand, and more excess funds go to this new place.
3) Prices rise, creating profits. More cash and leverage is made available to flow into this hot new thing. The additional demand creates higher prices. These provide profits for the old entrants.
4) Everyone wants in. Prices go up exponentially. More new cash is invested. A positive feedback loop results.
5) Eventually, someone notices the are standing on air about 1000 feet up, looking a little sick. Then gravity takes over.
Thus goes the theory of investing most people follow. It’s all very rational.
June 6th, 2009 at 9:30 am
“In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.”
Grantham’s view here is nothing more than scapegoating. I am no fan of efficient market hypothesis. How it escaped into the wild from its natural habitat in the faculty dining room should be the study of many investigations and books.
Maybe economic cycles are, like death, simply unavoidable. If that’s true, then it’s far more responsible to plan for the inevitable than to waste time thinking the inevitable can be avoided.
June 6th, 2009 at 9:37 am
Mans a rational animal so of course markets must be efficient? Perhaps so, back when man was mostly thought of as Puritan, and chaste.
June 6th, 2009 at 9:58 am
One major corollary of the Efficient Market Hypothesis — that passive index investing offers superior returns, on average, to active management — has not yet been toppled. And the evidence in its favor continues to accumulate, even through this current bear market phase. (Standard & Poors posts the annual results online for the active versus passive debate.)
If markets are “irrational” (meaning, I suppose, mispriced relative to probable future free cash flows) and can remain irrational for indeterminate lengths of time — “longer than you can stay solvent,” as the old saying goes — then rational fundamental analysis will yield little benefit in predicting market direction and investment returns. So another valid corollary of the Efficient Market Hypothesis remains standing: You (the average money manager) cannot consistently predict where the market is headed.
Other than that, a terrific article, especially where it talks about the over emphasis of market cap in evaluating company and executive performance.
June 6th, 2009 at 10:38 am
Efficient-market hypothesis was pushed pretty hard in my finance classes back in the early ’80’s- it seemed a bit hard to believe-
when you look at the ability of large market makers to manipulate the market- and ability of the average investor to let optimism cloud reality- as in the run up to 14,000- which made ZERO sense-
then the hypothesis loses credibility
June 6th, 2009 at 11:05 am
Fun read before the saturday crossword. Im a big admirer of guys like Grantham. He doesnt play the geisha with a fan covering his mouth while he flutters his eyes and talks his book. He shows his book and speaks his mind.
June 6th, 2009 at 11:09 am
[...] Myth of the Rational, Efficient Market: Big Picture [...]
June 6th, 2009 at 11:23 am
“who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all.”
It’s like connect the dots. If you are able to draw likely conclusions on how things eventually might play out given past scenarios, then you will be waiting on the herd when they finally arrive.
June 6th, 2009 at 1:16 pm
I think that what Mr. Grantham may have intended to imply is that EMH became a justification that many poorly informed individuals used to follow the crowd.
Just like many of the investment bankers who trusted quantitative analysis completely. The real number crunchers probably understood the real risk of trouble, but the problem is that many of the deal makers heard what they wanted to hear, and then assumed that mathematic genius was a prophylactic against risk.
I have had many of my friends (all laymen, not professional) breezily dismiss my concerns about the market two years ago, and they would nearly always attribute their confidence to EMH.
With regard to how efficient markets are, well I personally think that EMH does not easily take into account national manias like housing and the tech bubble.
The institutional memory of humankind is usually short, and nearly always highly unstable. There were certainly a number of voices warning about housing, but everyone from the delusional homeowner with a HELOC-funded millionaire lifestyle to the mortgage brokers, realtors, builders, and so forth were having a party. Go to a party some time and try to take the punch bowl away. Unless you arrived in a squad car and are wearing a badge and gun, you’ll not succeed.
A good friend of mine was a credit analyst at a bank where you got fired if you tried to avoid the worst of the toxic RE development loans. He tried his best to stop a few, but the management always ignored his analysis. Nearly all of his warnings turned out to be true.
But the management wanted their piece of the RE magic, and they wrote loans liberally.
I think that most of these failed operators whether it was Fannie/Freddie, Countrywide, Bear Stearns, Lehman or whomever were SO CONCERNED about not falling behind they guy they were racing alongside that no one noticed the cliff up ahead.
They were all very rational and efficient with regard to the factors that they cared about. But it is foolish to think that the market is efficient and rational at all times with regard to all aspects.
June 6th, 2009 at 1:38 pm
theSpartan writes “But the management* wanted their piece of the RE magic”
* you listed a bunch of party ‘iers that fillin that sentence fuller
if we learned anything this decade .. its if your gonna do something “Do It Big … Big is TBTF” c2009_TBP
June 6th, 2009 at 2:06 pm
I found compelling the following notions from the conclusion of this essay “The Market Organism: Long Run Survival in Markets with Heterogeneous Traders” by Blume and Easley
“This analysis suggests that, contrary to Henry Herrman’s view in the epigram which
begins this paper, the market knows not better but only as well as the (best) analysts
do. The market can be no better informed than the most fit trader according to the
fitness index metric, and if there are several most-fit traders with distinct beliefs, then
the market beliefs as expressed in limit equilibrium prices may fail to converge.”
and
“In studying prediction markets like those contracts traded on Iowa Electronic
Market which make book on political races, it is important to take account of learning
through prices, and to entertain the possibility that the accurate performance of these
markets is due at least as much to trader learning from prices (as opposed to more
`outside’ information) as it is to market selection. In our view, this is less important
when it comes to large markets for securities and other financial assets. This is not
to say that learning is not important; surely it is. But these markets are sufficiently
complicated, and trading occurs for so many diverse motives, that the possibility of
consistent learning rules seems to us remote. This leaves room for the market to be
smarter in the long run than its traders; and so we are led to ask, how is the market’s
learning experience different than that of its traders? The leading example of section
3.1 is a first step towards answering this question.”
June 6th, 2009 at 2:36 pm
Sheesh, people read way too much into the EMH. In its simplest form it basically says there is no free money you can get from arb. It says nothing about predicting future prices, etc. It claims nothing about reducing volatility of future prices.
It doesn’t even say arbitrage doesn’t exist, just that arb doesn’t return excess profits in the long run.
June 6th, 2009 at 3:42 pm
“In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.”
According to this people’s wrong thinking were responsible for the economic crisis of real capitalist world economy. That begs the question what causes the wrong thinking?
rc
June 6th, 2009 at 4:26 pm
People are not rational. The markets are run by people. Therefore, the markets are not rational.
June 6th, 2009 at 4:53 pm
As long as humans are making buy/sell decisions, the market will not be rational.
That’s a beautiful thing, for anybody that aims to systematically beat the market.
June 6th, 2009 at 9:53 pm
“All men are mortal. Socrates was mortal. Therefore all men are Socrates.”
Love that line.
One of the truly annoying things about reading the legal products of Posner and the “Law and Economics” crowd influenced by Chicago is that the cult members would always “spot the efficiency” in a transaction. That is/was their thing.
The desirability of insider trading and “efficient breach,” for example. Insider trading, some of the hardcore Chicago legal scholars hold, is “efficient” because money flows to the better informed.
Similarly, when a company can get cheaper parts from another supplier than the one they already have a contract with — and so breaches its contract to get cheaper parts and increase profit — these folks have been suggesting that the courts should disallow punitive damages because breaching the contract results in greater efficiencies.
So when I heard the deregulation crowd appealing to “sanctity of contract” as a basis for justifying the bonus nonsense at AIG and the banks I felt more than a twinge of irony and just shook my head.
June 6th, 2009 at 9:53 pm
[...] Joe Nocera column in the NYT (“an engaging history”). Perhaps most important of all, there’s the Barry Ritholtz instablurb: I am about halfway through The Myth of the Rational Market, and so far, its good wonky fun. [...]
June 6th, 2009 at 10:24 pm
transor Z-
or another one-
Native Americans are vanishing
Running Bear is a Native American
therefore Running Bear is Vanishing
June 7th, 2009 at 12:38 am
So would a rational investment strategy be to keep my money in a savings account most of the
time, then when a bubble occurs to invest in the bubble, double my money and get out before
it collapses? I think the problem is identifying when the bubble starts. Maybe, when it looks too
good to be true it must be a bubble?
June 7th, 2009 at 8:02 am
Transor Z Says:
So when I heard the deregulation crowd appealing to “sanctity of contract” as a basis for justifying the bonus nonsense at AIG and the banks I felt more than a twinge of irony and just shook my head.
——————-
You hit the nail right on the head!
These 100% free market types do not care about anything esle but themselves. They will use any kind of twisted logic to get their way because they only care about #1. They will destroy their country and the environment to enhance their wealth. That is exactly why 1 or 2 million$ is not enough and they need hundreds of millions… They know darn well that one day their destructive ways might catch up with them and force them to exile to a private island.
June 7th, 2009 at 8:31 am
“…any kind of twisted logic to get their way because they only care about #1. They will destroy their country and the environment to enhance their wealth.”
Starve the Beast, I always wondered what that meant. I think we are now finding out.
Can we officially say the Beast is Starved???
Maybe not yet, but we are getting closer day by day.
June 7th, 2009 at 6:02 pm
The market is neither efficient nor rational.
The EMH came about because someone mistook efficiency for the fact that markets are not *predictably* inefficient or irrational.
How this is news astounds me…
Keynes said it long ago. “The market can stay irrational longer than you can stay solvent.”
The people who beat the market consistently are not necessarily those who can identify the bubbles or other irrationality. The people who beat the market consistently are those who happen to make the right bets at the right time on when the bubbles or other irrationality will end (or begin).