Ilya's Reviews > The Myth of the Rational Market: Wall Street's Impossible Quest for Predictable Markets

The Myth of the Rational Market by Justin  Fox
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Nov 04, 2011

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Stock exchanges appeared at about the same time as joint stock companies, in the early 17th century. Mathematical analysis of the stock market had to wait until the early 20th century; it was done independently by a French and an American economist. They found that stock prices move more or less randomly; in a few years Albert Einstein used similar mathematics to analyze Brownian motion. This means that an investor no more has a way to predict the movements of a stock than a physicist has a way to predict the movement of a particle bombarded by molecules. In the 1930s through the 1960s economists have formulated a mathematically rational approach to investing, and asked themselves, what would happen if all the investors followed this approach? The answer associated with the University of Chicago was that stock prices would already reflect all publicly known information, so an investor who does not possess insider information cannot beat the stock market. After this answer, known as the efficient market hypothesis, became well known in the 1970s, it made fortunes for the inventors of the index fund, which simply invested money in the top 500 (say) companies by market capitalization instead of actively picking stocks; it did no worse than ordinary mutual funds, and did not have to pay the analysts' salaries. Other economists derived a formula for the cost of a stock option given the assumption of the hypothesis; it now became possible to insure one's stock portfolio.

Another school of economists associated with MIT pointed out problems with the efficient market hypothesis: if stock prices reflect all publicly known information, then an investor has no incentive to spend money acquiring this information, since he won't gain any new knowledge, but if he won't do it, how can stock prices reflect the information no one has bothered acquiring? Computer simulations showed that a market full of irrational investors will have prices that are nearly as unpredictable as one with rational investors, so the fact that the market is unpredictable does not imply that it is rational. Other studies showed that crowd psychology has a bearing on the markets: people tend to panic together, and become manic together. However, like in a Greek tragedy, no one heeded these warnings, and a huge building of modern finance was built on the shaky foundation of the hypothesis.

In the 1980s, the concept of shareholder value became popular in corporate governance, which meant increasing the stock price of the company above all, and compensating the chief officers of the company with stock options. This made some CEOs insanely rich and gave them the wrong incentive of pumping up the company's stock at the expense of its long-term prospects. The late 1990s saw a huge stock market bubble, which popped in 2000, but not before Cisco, the maker of network equipment with then 40,000 employees, briefly became the most valuable company in the world, with market capitalization over half a trillion dollars. Surely, this price was not efficient! The mid-2000s saw a real estate bubble, the popping of which unleashed a worldwide financial crisis. When Alan Greenspan testified before Congress in 2008, a Congressman asked him whether "you found that your view of the world, your ideology, was not right, it was not working"; Greenspan answered, "Absolutely, precisely." On the one hand, the efficient market hypothesis is clearly wrong; on the other, there is no grand theory to replace it, and as it is built into so much of modern finance, replacing it with anything will be difficult.
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Patrick It was an interesting review, (I "liked" it) but please remember that paragraphs are your friend.

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