The Myth Of The Rational Market.

For most of my investment career the Efficient Market Theory-that markets were all knowing and rational-was the prevailing view of how markets functioned. That theory has come under increasing scrutiny and question in the past several years. I personally think markets are efficient up to a point but in the main they are subject more by other factors such as human emotion, especially in the short term. Economist Justin Fox is out with a book on this subject. It is entitled "The Myth of the Rational Market". His publisher has a promo blog interview with him on its web site. Since I'll be coming back to this subject over time, I've decided to excerpt it for you today.

Link: http://www.byjustinfox.com/the-myth-of-the-rational-market.html

The Myth of the Rational Market

Financial markets were supposed to know better. They were supposed to be near-perfect processors of information and assessors of risk. They were supposed to be steering us toward a more prosperous, less economically volatile future. Then they failed, spectacularly. Justin Fox’s "The Myth of the Rational Market" tells the story of how we came to believe that financial markets knew best, and how that belief steered us wrong......It’s also a tale of Wall Street’s evolution, the power of the market to generate wealth and wreak havoc, and free-market capitalism’s recurrent war with itself.
The efficient market hypothesis—long part of academic folklore but codified in the 1960s at the University of Chicago—has evolved into a powerful myth. It has been the driver of trillions of investing dollars, the inspiration for index funds and vast new derivatives markets. In its strongest form, the theory holds that the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets. That belief has crumbled.
....A new wave of scholars .... no longer teach that investors are rational or that markets are always right. Many now agree with Yale professor Robert Shiller that efficient market theory “represents one of the most remarkable errors in the history of economic thought.” Today the theory is giving way to new hypotheses of market behavior growing out of psychology, physics, evolutionary biology—and even traditional economics. In his landmark intellectual history, Fox uncovers the new ideas that may drive markets in the century ahead.
A Myth of the Rational Market Q&A {Again excerpted}
What is the myth of the rational market?

Most simply, it’s the belief that financial markets can be relied upon to get things right. In the context of my book, it refers to the academic theory most commonly known as the efficient market hypothesis—although I often refer to it as rational market theory because that’s shorter and, for those of us who aren’t finance professors, clearer.

What is main takeaway of your book?

That financial markets possess many wonderful traits, but that rationality is not always among them. And that relying on markets to be right all the time can be a very dangerous thing to do.

Does your book explain the current financial crisis or any aspect of it?

Yes. Financial decision-making and financial regulation had been restructured over the past couple of decades around the notion that market prices are correct. If market prices and formulas built around market prices said one thing, the thinking went, then who was a Federal Reserve chairman or investment bank CEO to say they were wrong? It was a suspension of judgment on a mass scale, and it turned out really badly....

What are some of the practical lessons of the book and do they have any application to economic recovery?

The most important practical lesson of the book in the context of the current economic situation is that financial markets don’t know everything. They know a lot, and the signals they send shouldn’t be completely ignored.......Our society (and our financial markets) cannot survive and thrive if all decisions are left to the market.Oh, and one another practical lesson: Stocks are a much better long-run investment when they’re cheap by historical standards (as measured by price-to-earnings or price-to-book ratio) than when they’re expensive.

{Why did the} rational market theory........become so widely accepted as standard practice?

First of all, because the facts seemed to back it up. For example: Finance scholars argued in the mid-1960s that the superstar mutual fund managers of the day were beating the market only by taking crazy risks that would eventually backfire. Within a couple of years, most of those stars had flamed out. More broadly, rational market theory offered straightforward answers—some of them correct—to a lot of questions that had long plagued investors, corporate managers and regulators.

In recent decades, you note the theory traveled beyond the stock market to apply to other securities and especially to what came to be known as derivatives. Do you think this played a major role in the current economic crisis?Yes it did. Although it’s not perfectly rational all the time, the stock market does process information quickly and handles even really bad news in a mostly orderly fashion. The same can usually be said for the {other} organized exchanges in derivatives....The off-exchange markets for mortgage securities and over-the-counter derivatives never developed the rules and contingency plans characteristic of well-established exchanges, yet were still expected to perform the same functions. When hit by adversity in the summer of 2007, many of these markets stopped functioning entirely. That, as much as anything else, was what turned a financial problem into a crisis.

What can today’s investors learn from studying rational market theory?

The market isn’t rational, but neither am I......I’ve become increasingly dubious that in my spare time I can pick stocks or investment managers that will beat the market after fees.

What do you see as the future of Wall Street?

We’ll have a long period of rethinking and relative sobriety, and then make all the same mistakes (or at least similar ones) again in 50 years or so.

How did you come upon the idea of writing this book?

The particular thing that got me started was encountering a book in 2002 by a finance professor, Peter Bossaerts of Caltech, that said the efficient market hypothesis had outlived its usefulness. What interested me was that Bossaerts sounded almost wistful about it—he wasn’t an efficient-market critic, just a realist. I knew there was a debate about the efficient market. This was the first hint I got that it was more or less over.It led to a 2002 Fortune article titled “Is the Market Rational? No, say the experts. But neither are you, so don’t go thinking you can outsmart it.” Which in turn led to a book contract.....Oh, and lots of staring blankly at a computer screen.