Book Review: The Myth of the Rational Market

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.  The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.  I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.  Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.  My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).  I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).  Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.  I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.  As I read Justin Fox’s work, I admired its ambition.  This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.  It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.  This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.  Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.  Many of them came to my view that the market is pretty efficient, but not perfectly so.  Efforts at finding inefficiency promote market efficiency.  Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.  It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.  More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.  That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

  • Those who are too certain about their positions on market efficiency.
  • Those that assume that the market is always or rarely right.
  • Those that select asset managers, because there is a lot of volatility around investment returns.  What is luck? What is skill?  We know less here than we imagine.
  • Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.

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When I do book reviews, I actually read the books.  In the few cases where I scan a book, I reveal that in the review.  I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:  The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

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