The Myth of the Rational Market
By Justin Fox
The theory of efficient markets was once a “hypothesis” that was “subject to refutation by observable facts”, as Paul Samuelson put it in 1937.
But as the theory developed and financiers put more weight on it, it became a matter of established fact. By 1978, Michael Jensen could say that “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis”.
Then something strange happened. Sceptical economists showed that truly efficient markets were logically impossible. The theory’s own proponents embarked on empirical research that showed, beyond doubt, that markets were not as efficient as their theory supposed.
In spite of this, financiers built ever more on foundations that should no longer have been trusted. Last year’s events in capital markets were a definitive refutation of the theory. But anyone following the literature knew years earlier that markets were not efficient in the way that theories had predicted.
The theory has now completed its journey from “hypothesis” to “fact” to “myth”, to borrow from the title of Justin Fox’s excellent new history of the idea. Fox, a respected US financial journalist, covers ground that ranges from the notion of market efficiency – that market prices always incorporate all available knowledge about a security, with the corollaries that stocks will follow a “random walk” and that it is impossible to beat the market in the long term – to the panoply of models for measuring risk and pricing derivatives that came with it.
It is a history going back a century of how the idea came into being, and of the motivations of the economists who developed it. Fox makes painfully clear that the men who drew up the theory knew from the start that its assumptions, such as that stock returns follow a “normal” or bell-curve distribution, were unrealistic.
Perhaps most scandalously, the theory remained received wisdom long after empirical and theoretical arguments had demolished it within the academic community.
Joseph Stiglitz, now famous as a critic of globalisation, published a proof that the efficient markets hypothesis was logically impossible because otherwise it would be irrational to spend money on research.
More startling is Fox’s story of the University of Chicago’s Eugene Fama, who promulgated the efficient markets hypothesis in its most widely recognised form by combining it with the capital asset pricing model that portrays investing as a trade-off between risk and return. The key risk, known in the jargon as beta, is the sensitivity of a stock’s price to moves in the market as a whole. According to Fama’s theory, movements in stocks are random, except that high-beta stocks will be more volatile.
But in the early 1990s, Fama and Kenneth French published a large empirical survey of stock market returns since 1940 and found several ways in which returns were not random and which could not be explained by beta. In aggregate, smaller companies did better than larger ones, while “value” stocks, which are cheap compared with the book value on their balance sheet, also outperformed. There was even a “momentum” effect – stocks that had been doing well for a while tended to continue to do so.
Fox makes clear that this was tantamount to the founder of efficient markets admitting his theory was wrong and quotes the judgment of one critic: “The Pope said God was dead.” He is also scathing about Fama’s attempt to rescue the theory by categorising all these effects as “risk factors”. For example, a cheap company with a high price-to-book value was risky, and hence it generated higher returns for its investors. “This amounted to saying that the same company was a riskier investment at $5 a share than at $20 – a bizarre contradiction of the teaching of successful investors.”
All of this came more than a decade before last year’s implosion. So why did regulators continue to enshrine assumptions of efficiency in the rules they set? Fox points out that as early as 1974, efficient markets theory was embedded in US pension regulations; “No longer a legal concept based on tradition, prudence was redefined to mean following the scientific dictates of modern portfolio theory.” And why were investors prepared to risk so much on such a sketchy basis?
There is much more to this book, which is impressively broad and richly researched. But it is the realisation that the financiers who came to grief last year should have been fully aware that they could not rely on their own models that sticks in the memory.
The writer is FT investment editor