One of my favorite Saturday Night Live skits aired in 1994, the year of the Major League Baseball strike:
Super Sports Tours is proud to announce its 1994 Fall baseball cruise! On September 28th, it's all aboard the Pacific Queen for a week of fun and sun with some of your favorite baseball stars. Including:
…Baltimore's Cal Ripkin, Jr. And Chicago's Sammy Sosa. And Mark Grace. And the Tigers' Cecil Fielder. And the Red Sox Mo Vaughn. And also from the Yankees: Don Mattingly, and Mike Stanley, and Paul O'Neill, and Jim Leyritz and Danny Tartabull and Jim Abbott, and Randy Velarde and Gerald Williams and Matt Nokes. Annd don't forget about the Angels' Chili Davis, and Tim Salmon and the Padres' Tony Gwynn. And many more!
The commercial went on and on, literally rattling off a hundred names plus—at a certain point the sheer inanity and repetitiveness became funny. Well, consider Jonathan Fox's Myth of the Rational Market the financial equivalent of the Fall Baseball Cruise.
The book is a comically comprehensive recounting of the personas influencing efficient market theory, primarily over the last 100 years, but at times reaching all the way back to Adam Smith. Comical because, if you read the book's title and synopsis, you'd think you were picking up a book of theory arguing against the idea of rational markets. This ain't it. Instead, it's a history book touching on everything from economic theory to financial innovations to behavioral finance to accounting principles to investing gurus to corporate governance…and more!
Which is a boon and a bane. Boon, because it shows how deeply the idea of efficient markets has influenced economic activity over the last century. Bane, because the book's breadth ends up clouding the central question of market efficiency. On balance though, this was a worthwhile read.
What Is a "Rational" Market?
Among the greatest human technologies—ever—is market-based pricing. Just think of it—all possible information and opinion reflected in a single number! But we can only make that statement in a theoretical sense because in practice it's not so clean and easy. There really is no "pure" market—distortions exist. Similarly, there is no "rational man" that always makes well-informed decisions, yet most economic theory is predicated on him.
So, pure theorists tend to dwell on the wrong issues when it comes to market efficiency. It ought to be self evident people aren't fully rational, nor are markets fully efficient. The question for a practical person is whether markets are the best mechanism available to create pricing information and move capital to where it's best used. It's particularly appalling how often markets' adaptive features are ignored in academic debate. When mistakes or "irrational" decisions are made by real people (which is constantly), it's spellbinding how nimble and able economies, capital, and people adapt in a market environment versus, say, government bureaucracies. This is what makes Fox's book so fascinating: it's a tremendous panorama of the impractical debates that have dominated economic thought for decades.
Learn from the finance pros! Like Kenneth Arrow, Roger Babson, Louis Bachelier, Henri Poincare, Fischer Black, Myron Scholes, John Bogle, Warren Buffett, Alfred Cowles III, Irving Fisher, Eugene Fama, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Ayn Rand, Michael Jensen, Daniel Kahneman, Richard Thaler! And many more!*
My own definition of market efficiency doesn't include anything about rationality. It's about bringing all the adaptive intelligences and perspectives—dumb and smart and all in between—together to reveal the true prices and values of things over time, better than any one mechanism, person, committee, or equation can. It's not that anyone is perfectly informed, it's that the balance of opinions tends to tease out the most accurate result over time.
So…markets are hugely efficient in the sense they generally reflect what's widely believed to be true. Which means they aren't always right, but are right more often than anything else we know of. That also means they aren't a "random walk" of perfect rationality. Markets are as human as…humans.
In the short- or medium-term, markets can gyrate wildly and disengage from economic reality. But a simple overlay of corporate profits and stocks over time shows how closely these two things match in the long run, and how stock prices are consistently the best forward-indicator of future economic activity. But markets do need an overlay of strong property rights, oversight, transparency, limited and non-politicized institutions like the Fed, and also mechanisms to stabilize liquidity when appropriate. For two reasons. One, confidence is a key to market activity, and we need enforceable, stable rules to get that. Second, capitalism is sometimes wild and features occasional upheavals we're not willing to put up with as a society. Pundits tend to describe this as a "shortcoming" of capitalism. It just is what it is—if we as a society decide to dampen capitalism's "animal spirits" for social reasons, that's a moral/social decision, not an economic one. Free market advocates (like me) tend to bristle at the creation of governmental stuff that doesn't serve either of these two purposes (which unfortunately constitutes a lot of bureaucratic oversight), but only adds a layer of inefficiency. (I'm willing to bet, for instance, any new oversight committees created by the new financial overhaul will have a dismal record of overseeing so-called "systemic" risks.)
Economics: Not Fully Science, Not Fully Math
Another key lesson of the book: Economics isn't even close to being a hard science, and much of finance is the same. Yet, economists have argued stridently for decades that they are. It's simply delightful that Fox spends time arguing finance and economics owe much to philosophical scientific thinkers like Thomas Kuhn and Henri Poincare…and then uses them to display economics shortcomings based on those metrics. It both reveals economics as a social science and deepens our understanding of how "hard sciences" actually work.
For example, take the notion of "equilibrium" prices—the foundational metaphor of classical economics, borrowed from the hard sciences. Only in theory is equilibrium even a possibility for markets. There's no sense in contemplating it in the real world. The idea gets constantly misapplied: a price is agreed upon by separate parties, it's not a natural reverting point of settlement. Instead, markets (and prices) adapt and react in a continuum of dynamic, complex, and ever-changing circumstances. There's never a point at which we settle upon an "equalized" state, as if markets were somehow homeostatic.
…other superstars of economic history like John Maynard Keynes, Hayne Leland, Mark Rubenstein, Robert Lucas Jr., Fredrick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Myron Scholes, Merton Miller, Franco Modigliani, Wesley C. Mitchell, Oskar Morgenstern, John von Neumann, MFM Osborne, Victor Niederhoffer, Harry Roberts, Richard Roll! And many more!
Here is where Fox delivers his best insights: asserting that theoretical economic theory infected finance in the last decades—a field that once upon a time was concerned only with practicality. Essentially, finance started using the theory of pure market efficiency as a baseline for pricing assets. The result is bad accounting rules like FAS 157, which rely too much on market-generated prices where there isn't enough liquidity or price discovery. In theory, it should work; in practice, it doesn't.
Financial equations work great when circumstances are known and probabilities are clearly and easily assigned, like with a coin flip (only two possible outcomes and they're both known). Anytime real uncertainty is added—that is, where the probabilities are not known but can only be guessed (which is how most of the economic world works), the math behind finance becomes grossly inadequate and even dangerous. This is why, for instance, bonds are somewhat easier to price than stocks, and the mathematics for bond pricing is more developed. Bonds have an end date, which makes the math for pricing them more reliable. Stocks have no end date, and thus there is no math in the world that can forecast a reliable price consistently. (This isn't to say future bond prices can be gamed by math alone, there is still an element of uncertainty, just generally less than stocks.)
Theories Do Matter
Fox finishes what turns out to be a very fine book about the history of market efficiency with an important lesson: philosophy matters. It shapes how we interpret events, and how we decide to act. Theory is one of the vital ways we make sense of a chaotic world. And, even when it's all hypothetical, theories are hugely important to how the real world ends up going. A few paragraphs ago, we were pretty hard on equilibrium. But then again, its ability as a concept to help us create economic models and heuristics has been a very useful thing.
One of the all-time free market fundamentalists, Ayn Rand, ranks as among the most lucid on the importance of theory and philosophy. Her nonfiction work, Philosophy: Who Needs It, is one of the most turgid but cogent books available on the nature of ideology, theory, and philosophy, and its role in real world decision-making. The prevailing worldview—however conceptual—shapes our decisions and opinions.
Fox's book is exhaustive, but he has a light touch and a good feel for the material. If you find yourself soul-searching about capitalism and free markets these days (many are), this is a good place to go.
…hear the spectacular finance insights of Barr Rosenberg, Stephen Ross, Mark Rubenstein, Paul Samuelson, Leonard Jimmy Savage, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Amos Tversky, Edward Thorp, Jack Trainer, Meir Statman, and Holbrook Working…
…and many more!
*All these names were pulled from the book's appendix, which is an exhaustive list of the cast of characters described in the book.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.