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On Wall Street, the Price Isn't Right

Sunday, June 7, 2009

THE MYTH OF THE RATIONAL MARKET

A History of Risk, Reward, and Delusion on Wall Street

By Justin Fox

HarperBusiness. 382 pp. $27.99

The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis. This theory holds that stock and bond markets are nearly perfect -- even during such crazes as the dot-com mania -- and that prices on the exchanges instantly and accurately reflect the available information about publicly traded securities. After the market crash of 1987, Yale University economist Robert Shiller called that belief "the most remarkable error in the history of economic theory." He could have said "most harmful error" as well. Yet it lived on and contributed mightily to the mortgage bust.

One presumes from the title of Justin Fox's "The Myth of the Rational Market" that he has come to bury, not to praise. And certainly, the opportunity for such an undertaking is rich. Proceeding from the assumption that economic actors are unerringly rational, the theory's disciples have endowed market prices with the wisdom of every moment. Thus, at 2 p.m. on a Wednesday, the Dow Jones Industrial Average reflects the accumulated financial knowledge of civilization, and equally so at 2 on Thursday -- even if the market has moved hundreds of points in the interim.

How did this faith in the supremacy of market group-think do us harm? For one, as the dot-com and other manias demonstrated, the crowd occasionally gets it wrong. The mistaken faith in markets turned regulators into fawning groupies. Notably, former Fed chairman Alan Greenspan doubted that he or anyone else could detect -- or regulate -- a bubble in advance.

The power of the doctrine was its grand design: the comforting notion that the financial universe adhered to absolute laws. But that was also its flaw. Prices couldn't be wrong; if they were, someone would seek to profit from the error and correct it. The illustrative joke was of two economists who spot a $10 bill on the ground. One stoops to pick it up, whereupon the other interjects, "Don't. If it were really $10, it wouldn't be there anymore."

Theorists such as Eugene Fama decreed that if prices are unforeseeable, then the future direction of the market is random. And if the market is truly random, prices should follow what mathematicians call a bell-curve distribution. In nature, this works. We don't know whether your neighbor will be tall or short, but we can predict, with pretty close approximation, how many very tall people will live in your town. In nature, extreme results such as a village of seven-footers will never occur.

Fox tells the story of how financial engineers assumed that markets would behave the same way, with generally predictable variances in prices. In particular, the theory of option pricing, the cornerstone of modern finance, has built into it the assumption that prices are random. The theory was devised by Fischer Black, Myron Scholes and Robert Merton. The last two won the Nobel Prize in 1997 and were partners in Long-Term Capital Management, the hedge fund that blew up in 1998.

What happened to LTCM? It turned out that in financial markets, extreme events do happen. People get emotional and decide to buy (or sell) in unison. All of LTCM's trades went sour simultaneously. Nonetheless, the modelers kept at it. Rating agencies assumed that subprime mortgagees would behave in random fashion -- large numbers of people would never default at the same time, right? (Oops.)

Fox, a business columnist for Time, spins a fascinating historical narrative, beginning with economist Irving Fisher's paean to markets in, alas, 1929. Postwar economists such as Paul Samuelson noticed that most investment pros do not beat the averages. This led to the one positive contribution of the efficient-market hypothesis: Jack Bogle's invention of index funds, which mimic the performance of the stock market as a whole and keep ordinary people from wasting their money trying to beat it.

Fox recognizes that true believers in the market's efficiency suffered from a "blinkered" mindset and "tunnel vision." Yet I think he lets them off too easily. He laments (as if it were necessary) the lack of any alternative "grand new theory" and finds that the debate has resulted in a "muddle." Fox concludes, "If you do come up with an idea for beating the market, you need a model that explains why everybody else isn't already doing the same thing." Not necessarily. Markets aren't physics. Maybe no one model explains them.

The emerging school of behavioral finance fills in many of the gaps left by the efficient marketers. Behavioral finance, which Fox discusses at length, holds that financial man -- far from the perfect, mechanical trader depicted in textbooks -- is a rather neurotic fellow. He follows the crowd, fails to plan ahead and often makes mistakes. To think that his every price is perfect is a remarkable error indeed.

Roger Lowenstein is the author of "While America Aged." His next book, "The End of Wall Street," will be published in 2010.

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