The Myth of the Rational Market

"Yes, so everything was working fine. The original concept – which started under Carter but was accelerated under Reagan – was that government has gotten too unwieldy. Regulation is too costly, too time-consuming and there’s too much red tape. There is a legitimate argument that bureaucracies tend to feed on themselves, and you have to constantly hack back at some of the vines and undergrowth. But somehow, “Let’s clear out some regulations and make it easier for business,” morphed over time to become, “The market knows better than anybody else, let’s get rid of any and all oversight, any and all regulation, any and all things that get in the way of the efficient market.” So what started out as, “Let’s clear out some of the excesses,” became, “Let’s get rid of all the rules.” Get the weekly Five Books newsletter In The Myth of the Rational Market Justin Fox explains all of the bad ideas that took root and allowed a very legitimate and worthwhile objective – getting rid of some of the really time-consuming, unjustifiable, expensive regulations that had grown over time – get so wildly imbalanced. He looks at why academics and many market theorists were so wrong about how markets actually operate. He does a wonderful job of telling the story of how the simple concept of the efficient market, the rational economic actor, got completely out of whack. You don’t have to be an economist or market theorist to appreciate the personalities, the stories, and some of the obvious delusions that took place and helped set the table for the collapse. It really does. By the way there are a bunch of other books along the same concept – Zombie Economics by John Quiggin, Yves Smith’s Econned , and Kevin Phillips’s Bad Money . There are a slew of these that are all about how academic economists – and especially the Chicago School and other believers in the Efficient Market Hypothesis (EMH) – got this totally wrong. There’s a simple reason for that, which is that when you build a model, you’re building a Platonic shadow of reality. It’s not reality; it’s a depiction of reality. Naturally, there’s going to be some variance and modelling errors. There’s that great George Box quote: “All theoretical models are wrong, but some are useful.” What that means is that you have to always remember, when you’re working from a model, especially a financial model making projections into the future, that you’re not dealing with a perfect reflection of everything that takes place in the real world. There are irrational things that take place that models typically don’t forecast. Human beings are not perfectly efficient, profit-maximising actors. And yet, that’s where things ultimately ended up going. By the way I do agree that A Random Walk Down Wall Street reached the right conclusion, but it was for the wrong reasons. It’s not that markets are mostly efficient, it’s that human beings are so irrational. We engage in such emotional decision-making – especially in times of distress – that we’re just not built for making intelligent decisions in capital markets. I’m just in the middle of reading Daniel Kahneman’s new book, Thinking Fast and Slow . You only have to read the first five to 10 pages, and you realise that human beings have no place making any decision other than: I hope I remember to put on pants today and let me not eat something unhealthy. Beyond that, our cognitive processes, our ability to make intelligent decisions, are so flawed, it’s just astonishing. The average investor is probably better off dollar cost indexing – putting the same amount of money every month into a broad index, rather than trying to pick stocks."