Lynn Stout on "The Myth of the Rational Market"

Here are Lynn's thoughts for the Club:

The Myth of the Rational Market is a book about the intellectual history of financial theory.  Described thus, you might think it would make readers’ eyes glaze over.  But Justin Fox makes the intellectual history of finance fascinating: full of drama, intrigue, conflict, triumph, and defeat.

He accomplishes this by focusing not only on the key ideas of 20^th century finance, but also on the personalities who developed those ideas.  (Like any good playwright, Fox provides his readers with a  “cast of characters.”)   He describes the tragedy of Irving Fisher, “the greatest American economist of the first half of the twentieth century,” now remembered mostly for his ill-timed 1929 prediction that the stock market had reached a “permanently high plateau.”  He recites the intellectual odyssey of Michael Jensen, a guru of market perfection who became enthralled in his later years with the idea that markets rely on the integrity of those who participate in them.  And—delightfully and at last—he tells the tale of Jack Treynor.  (Treynor’s story is known to many in finance, but few outside it.)  In the late 1950s, Treynor, then a consultant at Arthur D. Little, developed what is now widely conceded to be the first Capital Asset Pricing Model (CAPM).  He showed his draft to John Lintner of Harvard Business School, who passed the manuscript on until it eventually found its way into the hands of William Sharpe, a UCLA economics doctoral candidate.  Sharpe published his own version of the CAPM in September 1964, and in 1990 was awarded the Nobel Prize in Economics for his work.  (Note to Nobel committee: Jack Treynor is alive and well in California, and it’s not too late to call.)

With stories like these, almost any good writer could make finance palatable.  But Fox does more; he not only brings out the personalities of 20^th century finance, he also brings out the “personalities” of finance theories themselves, including the tantalizing utopia of the rational, efficient market that prices all stocks at fundamental value; the Black-Scholes options pricing model with its hidden but fatal assumption that the future will repeat the past; and Jensen’s “agency cost” theory of the firm, the intellectual origin of modern managers’ obsessive quests to increase “shareholder value.”  He shows how these ideas eventually were challenged by, and have had to wrestle (often to an uneasy standstill) with new theories, like the idea of irrational investors whose emotions and “adaptive expectations” cause them to trade too much and to systematically under- and overvalue securities.

It should now be apparent I am a serious fan of this book.  Nevertheless, like any good reviewer, I feel compelled to suggest there was one more story, and one more personality, that Fox perhaps should have mentioned.  This is the tale of how finance theory has tried to ignore the problem of “heterogeneous expectations,” meaning the reality that investors subjectively disagree with each other in their predictions for the fate of the market.  When William Sharpe first tried to publish his CAPM, it was rejected by reviewers at the Journal of Finance on the grounds that his assumption that investors  have “homogenous expectations” (make identical estimates of the risks and expected returns from different securities) was too unrealistic.  Sharpe managed to convince the Journal the CAPM still had value, and his paper was eventually published.  Ever since, most modern finance models explicitly or implicitly assume homogenous expectations.  But in 1977, Edward M. Miller published a ground-breaking paper in the Journal of Finance arguing that if investors disagreed, one could expect bubbles and crashes and stock prices might easily fail to capture fundamental value.  Because Miller’s paper flew in the face of the idea of a rational and omniscient market, it was highly controversial, and he has since moved away from the shark-filled waters of finance to write on less contentious topics, like IQ and race.  But after the Crash of 1987, Miller’s idea of investor heterogeneity has begun to creep back out from the shadows, and a number of contemporary theorists have been bold or foolish enough to explore how it might explain anomalies like the 1990s tech bubble, or stock markets where every share trades hands on average every four months.

But this is only very, very small defect in an otherwise wonderful volume.  The Myth of the Rational Market is now full of my notations, and I plan to keep it on the shelf near my desk for many years.