Book Review: The Myth of the Rational Market

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Fox, Justin. The myth of the rational market : a history of risk, reward, and delusion on Wall Street. Harper Business, 2009.

Two economists spot a $10 bill on the ground. One stoops to pick it up, and the other advises, “Don’t. If it were really $10, it wouldn’t be there anymore.”

Anyone who has taken a basic course in economics or finance knows that this joke alludes to the efficient market hypothesis, which holds that the market is always right. Prices can’t be wrong. If they are, someone would seek to profit from the error and correct it. The decisions of millions of rational investors, all acting on information, provide the best judge of an asset’s value.

This theory is the basis of a risk management and pricing system that underlies our global economy. But is this theory correct? Time columnist Justin Fox tells the story of the faculty members who designed complex financial theories. He focuses on the academic debate, explaining the theories of economists, such as Modigliani, Miller, Markowitz and Merton. Academics constructed models for managing uncertainty, which inspired the first index fund, the rise of derivatives and modern portfolio theory. Then in 2007 asset markets throughout the world collapsed, proving that the ideology was incorrect.

After the market crash of 1987, Robert Shiller called the efficient-market hypothesis the “most remarkable error in the history of economic theory.” Yet even after the disaster, the theory continued to thrive, only to contribute to the latest crash. Recently, Paul Krugman called the hypothesis “beautiful, comforting and, above all, lucrative.” It is not going away anytime soon.

© Reviewer: Meg Trauner & Ford Library – Fuqua School of Business.
All rights reserved.

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