By Ink Alone: Myth of the Rational Market
by Matt Stevens
Justin Fox, an economic columnist and blogger for Time, released a book in June 2009 detailing the rise of the Efficient Market Hypothesis. His tear down of the failures of theories is an interesting read but only for his writing ability. Fox does such an efficient job of pointing out the market’s inefficiencies and irrationality that the book seems almost like a study in restating the obvious. Fox succeeds at telling the story well by using clever anecdotes. However, the book is not a must read except for who are caught up in the stock market.
HarperBusiness (June 9, 2009)
Fox is one of my favorite economic bloggers. He enjoys pouncing on unusual stories that often plague the economic sphere and that contradict our understood notions of the proper flow of economics. When I saw that he had released this book that is mainly about the stock market that also hints at other aspects of the market (such as derivatives, futures, options pricing), I hopped right into the waiting line at my local library (Go Dakota County!) and put my name on the list. Sadly, this book was not what I expected, but what I should have expected had I read a little about the theory beforehand.
The Rational or Efficient Market Hypothesis (EMH) says that the price of bonds, stocks, or any other somewhat liquid asset “already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.” This is what I was taught in my entry level finance class in college. Turns out it’s not true.
Fox starts with Irving Fisher, since he’s the first celebrity economist. (Adam Smith lived with his mother and was a professor of rhetoric*–NOT an economist). Fisher’s assertions were that whatever the market was doing, it was right. And then he lost millions in the 1929 crash. But Fox traces the rise of the EMH, particularly the impact Eugene Fama of University of Chicago, and then how others couldn’t disprove the theory. Even more importantly, finance professors couldn’t make money in the stock market, so it had to be true. Then Fox discusses various people in the 1960s, 70s, and 80s who eventually figured out how to make money using the efficient market hypothesis, but slowly fell away from its teachings. He discusses at length the important people of the 1980s who made millions in the market by options pricing schemes and the rise of hedge funds.
One thing I think that Fox gets perfectly right is discussing how the theory is built upon a set of models and assumptions that are repeatedly proven false-such as, all actors act rationally, information permeates and that information is understood or known by all. As each of these assumptions get torn down, professors and finance geeks accept their removal, but stick to the theory. It’s kind of like a one-way bridge that is touching the ground on its destination side, but most of the bridge supports going into the river have been torn out and the starting side is only connected by a sliver of road: yet it is being held up by sheer will power of people who have crossed it or are in the process of crossing it.
Fox is an entertaining writer. But in the end, this book really isn’t that great. If you are tied into the market and want to believe you are smarter than the market and that you can beat it, then this book is for you–hopefully it will disabuse you of those notions. However, if you are of the belief that it’s extremely difficult to beat the market or the standard indices, like I am, then this book isn’t going to do much for you. It’s interesting, but not important for 95% of Americans. Unless you can devote eight hours a day to your stock and bond portfolio, then you should look at it once a month at most.
Two out of Five Melons.
*One can make a very good argument that Smith’s Wealth of Nations was actually a Rhetorical study. Smith used great descriptions and similes so that the images and ideas were easy to understand. But that doesn’t necessarily mean they were all accurate.