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Financial Happenings Blog
Thursday, June 18 2009

For those interested in the theories behind how markets work, Dimensional's Weston Wellington has posted his latest commentary piece looking at the topic of the efficient markets.  Weston focuses on the writings of Justin Fox who criticises the theory.  Unfortunately Fox cannot identify where investors are exploiting this lack of market efficiency.  His conclusion is that investors are best served by employing a buy and hold strategy.  Weston's full commentary is set out below.

Scott Keefer

Over six years ago, Fortune writer Justin Fox wrote an article titled, "Is the Market Rational?" Much of the article focused on the intellectual rivalry between two Chicago professors?Eugene Fama and Richard Thaler?and Fox made no secret which of the two he found more persuasive. The next generation of finance professors, he said, were "ripping Fama's teachings to shreds," and market efficiency as an organizing principle was being shouldered aside by something called "behavioral finance." In this view, irrational investors make systematic judgment errors that produce predictable patterns in stock prices. Fox noted approvingly that the Nobel Prize in economics had been awarded the previous month to a Princeton psychology professor in recognition of his work on behavioral biases and suggested it was possible for investors with sufficient "contrarian gumption" to outperform the market by exploiting such biases. But he doubted most of his readers would be successful in this effort, due to their own propensity to make mistakes. His conclusion for investors? "That's easy," he wrote. "Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control?costs?and keep them as low as possible."

Fox has been hard at work since that time; the article has mushroomed into a 328-page book and the title is no longer a question but an assertion: The Myth of the Rational Market. The book has much to recommend it?a wide-ranging survey of the battle of ideas among financial economists over the last century, with an enormous cast of characters. Readers of Peter Bernstein's Capital Ideas will find themselves covering familiar ground, but there is enough new material to make it worthwhile. Fox's breezy style is effective in distilling complicated ideas into digestible portions, and his colorful sketches help maintain our interest in a dry, statistics-laden topic. Social critic Thorstein Veblen, for example, is a "crotchety philanderer." Yale economist Irving Fisher is a prohibitionist and health-food advocate. Milton Friedman finds the early research on efficient portfolio design similar to his work during World War II on the statistical properties of artillery shell fragmentation.

Financial economics as a distinct field of inquiry has grown from humble beginnings in the 1950s to a major field of study, and Fox takes the reader on a long journey in his effort to find a comprehensive explanation for the mystery of markets and rational behavior. Perhaps too long. One knotty problem leads to another; and even with greatly condensed versions of all the various issues, the progress is slow. Only those with considerable intellectual curiosity are likely to make it all the way through the discussions of random walks, asset pricing puzzles, expected utility theory, fractals, futures contracts, game theory, organizational behavior, corporate governance, central bank policy, derivatives, behavioral biases, and on and on.

There is so much ground to cover that some intriguing questions are left barely explored. After pointing out the flaws of the efficient market hypothesis using the CAPM model of expected returns, Fox quickly dismisses the alternative Fama/French multifactor approach as "clunky" and moves on. The value premium, in his view, is attributable primarily to investor irrationality. This is certainly one interpretation, but a more nuanced view deserves attention as well. Chicago Ph.D. and hedge fund manager Cliff Asness has pointed out that despite the extensive literature on the issue, an explanation for the value premium remains a "gigantic, subtle, and still unsettled academic debate."

For those hoping to find some concrete suggestions for improving their investment results, the book is apt to be disappointing. Fox finds little evidence of success among professional money managers in exploiting the inefficiencies he believes are so clearly evident. He has some kind words for academics who have set up money management firms to apply research on behavioral biases to generate superior returns, but he cites no evidence of their success, perhaps because their results are generally well explained by the standard asset pricing models he is so quick to condemn.

Fox appears frustrated that the evidence of market irrationality appears so clear but the evidence of investor success in exploiting these mistakes is so thin. His brief message to investors toward the end of the book carries an air of resignation?all the effort devoted to identifying flaws in the rational market model doesn't appear to offer hope of a superior approach. Almost as an afterthought, his practical advice to investors includes the following suggestions:

  • "If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are. You don't have to stop there. But 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 you are."
  • "If you're picking somebody else to manage your money, the chances of finding a market-beating path are even harder."

Bottom line: Ideal way to bone up on financial economics if you want to sound like a know-it-all. But it's unlikely to change anyone's mind with regard to the optimal investment strategy.

Asness, Clifford. "The Value of Fundamental Indexing." Institutional Investor, October 19, 2006.
Bernstein, Peter. Capital Ideas: The Improbable Origins of Modern Wall Street. Hoboken, NJ: Wiley, 2005.
Fox, Justin. "Is the Market Rational?" Fortune, December 3, 2002.
Fox, Justin. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. New York: HarperBusiness, 2009.

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