The Myth of the Rational Market by Justin Fox, Book Review Example

For the purposes of this book review I will express and briefly analyze two (2) critical ideas from each of sixteen (16) chapters of The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street by author Justin Fox.

In Chapter One, Irving Fisher Loses his Briefcase then Loses his Fortune discusses in the 1900’s the stockholder actually ran Wall Street and the public had no say so in what went on the financial ends in New York. Concepts of Wall Street historically began to change through the works of an avid and intellectual Yale professor and graduate, Irving Fisher which adorned the desks of economist, financial consultants and hedge fund managers after his death in 1947. Fisher is known as the ‘father of modern Wall Street’.

Fisher was ahead of his time with his theories of evolution with application to mathematics by questioning what give a product value. Fisher had an upper hand on others because he was not only an economist but he was a mathematician. Fisher reasoned that as prices would drop so would interest rates thus the economy would not be hurt. This was his philosophy of equilibrium economics. What was most astounding was Fisher’s proposal to incorporate ‘uncertainty’ into the equation of economics-enabling investors to use present values to price bonds and stocks. Though many of his ideas were not necessarily believed then when he predicted the Stock Market Crash in 1929, but his principles are believed and followed today.

A Random Walk from Fred MacCaulay to Holbrook Working, Chapter Two John Maynard Keynes became famous for his economist theories of which many young scholars disciplined themselves to study and make documentations after his works. Many of the works resembled those of Irvine Fisher’s but no one gave credit to Fisher. The players of the stock market instead took opinions of what the ‘average’ person would do.

Keynes went against Fisher’s recommendation to print more money; hence he thought it necessary to spend more money. Cowle’s invited Fisher to join him with a venture in Europe and published an article Can Stock Forecasters Forecast? No They Can’t! Cowles learned that stock indexes were likely to keep moving in the same direction from thirty minutes to three years. They began to understand the rising and falling conditional patterns of the economic market.

In Chapter Three, Harry Markowitz Brings Statistical Man to the Stock Market, speaks of Harry Markowitz’s beliefs about balancing risks and returns with relation to wartime calculations on bomb fragmentations. Markowitz explains the theory as deciding how much power do you want to sacrifice to increase your probability of hitting the target?

In relation to economics and the stock market the question to ask is how much return do you want to sacrifice in order to increase the probability that you will get what you asked or made plans for? The answer to this question in both militia aspects and economics is ‘safety first’. Achieving economic equilibrium by taking care of uncertainties is the means to keeping economic stability which is similar to the game of poker.  This accomplished through assigning a number to an uncertainty by maximizing the number (quantitatively). This is the same concept Irving Fisher introduced. Mathematicians introduced the mathematical theory in the 1700’s and Fisher introduced the theory into economics. Markowitz supported
Fisher’s theory of uncertainty and further stated the theory should be weighed proportionately when assigning a maximum value.

Chapter Four, A Random Walk from Paul Samuelson to Paul Samuelson, Paul Samuelson theorized an ideal competitive market was one that possessed an equilibrium yet was constantly being disturbed but was able to reform itself. He compared this to the surface of the ocean that was ‘unable’ to reform itself. These mass contagions could simply be swept under the rug in hopes of reformation. People buy in hopes that the market will rise in a ‘bullet market’ and this act sends the prices up.

Samuelson attempted to add a fifth strategy to the stock market in which to gain an edge on the majority of market players. He recognized that Bachelier’s theory of the market was similar to Albert Einstein’s theory of Brownian motion-the random movement of microscopic particles suspended in a liquid or gas.

In Chapter Five, Modigliani and Miller Arrive at a Simplifying Assumption academic finance and economics are transformed into practical and rule of thumb theories. Jimmie Savage and Milton Freeman published a book detailing their own theory of the ‘real’ way people made their investment decisions.

They developed a ‘wiggly utility curve’ to determine what individuals make choices to by stocks and things such as lottery tickets. Then they determined that a theory is only as good as observations and testing to prove it.

Gene Fama Makes the Best Proposition in Economics, Chapter Six give rise to Chicago’s economist, Melvin Reder, that the economy would remain stable as long as the government had no direct interference in it. He shared a different viewpoint from counterparts from MIT, Yale, Harvard and Stanford. This was called the ‘tight prior equilibrium’ theory whilst other theories were called the ‘diffuse prior equilibrium’ theories. Reder saw government interference as a threat to freedom and financial solidarity. His reasoning was that with those in government in charge there is no feasible way for them to know all to be done.

Jack Bogle Takes on the Performance Cult (And Wins), Chapter Seven speaks about Edward Reshshaw and Paul Felstein’s bright ideas to start a mutual fund that buys and holds the stocks in the Dow Jones industrials average. This method would be a low cost alternative to picking mutual funds as individual stock option purchases. John Bogle argued months later that an unmanaged fund was a ‘disaster waiting to happen’.

In 1924 a Boston stockbroker acknowledged that amateur investors were fleeced by the stock market and it was due time for a new way to invest. It is through this history that the formula for calculating the present value of projected future dividends became part of every stock and financial analyst’s briefcase.

Fisher Black Chooses to Focus on the Probable, Chapter Eight characterizes how to measure and control financial risks whilst keeping profit margins high or out of the negative. In London, 1952 professors predicted a fall of the stock market well under the normal curve of distribution.

Osborne focused on the anomalies behind the statistics and helped to predict stock market decline of the 1970’s. This declination left Wall Street and less reluctant to listen to anything in the future.

Michael Jensen Gets Corporations to Obey the Market, Chapter Nine discusses how the ‘efficient market’ began to find its way into corporate America. Market corporations were originally created in the Netherlands and the United Kingdom for the good of the economy but not always used in that manner. It was already established in the late1700’s that joint owned stock holders were disastrous because no one can manage the monies of others.

Aaron Director was part of the opposition to government control in the stock market and pronounced his ideals about monopolies such as General Motors becoming too powerful. He further shared that lawmakers were acting in their own interests and could not be relied on to do what was best for the whole of the economy.

Dick Thaler Gives Economic Man a Personality in Chapter Ten describes the application of micro-economics to the business cycle and shows mathematical concepts can e applied to predict human behaviour with relation to finance and stocks. The chapter compares and contrasts the statistical bias of applying the rule of thumb versus statistical calculation and shows that humans will not consider all bias.

People have unlimited time and brainpower to devote to decision making hence they resort to applying the ‘rule of thumb’. This is not the most accurate way to make financial decisions but is the accepted way for the average person to do so.

Bob Shiller Points out the Most Remarkable Error in Chapter Eleven of the book by showing already established or ‘convincing evidence of rationality’ for the financial market is severely lacking. It was established that the random walk hypothesis as a good approximation, but with the understanding that it is consistent with fairly long-lasting disequilibrium. There is nothing fundamental about financial market prices for they are intrinsically difficult to manipulate.

It would surely come as a surprise to a layman to learn that virtually no mainstream research in the field of finance in the last decade has attempted to account for the stock market boom of the 1960s or the spectacular decline in real stock prices during the mid-1970s.

Beating the Market with Warren Buffet and Ed Thorp, Chapter Twelve, focuses on people that beat the market that were not professional group investors but acted as professional investors in that they made huge profits with smart investments. “There will always be discrepancies between price and value in the market and those who read their Graham and Dodd will be the successful ones”, says Buffet.

California math professor turned hedge fund manager; Ed Thorp was also successful with investing. Both made millions investing in hedge funds. Investors will not desert the funding when stock prices are high; they will simply pour in new money. Buffet followed the teachings of Ben Graham by buying companies with a stock market below value.

Alan Greenspan Stops a Random Plunge Down Wall Street in Chapter Thirteen as the Crash of 1987 persists; the Federal Reserve comes to the rescue. Hayne Leland determined that the effects of the trade offs in the market took about seven years to surface.

After the launching of the S&P 500 in 1982 his business began to soar. He could promote his business simply by buying and selling market index futures. Pension funds immediately became more attractive to the investment world. They followed financial advisors and sold in 1987 and to their astonishment they ‘lost, lost, lost’. It was clear that risks could not be determined by financial analysts. The process of quantifying risks in the stock market is ‘for the birds’.

Andrei Shleifer Moves Beyond Rabbi Economics, Chapter Fourteen, illustrates how an irrational market can be just as ‘persuasive’ as a rational market. Andrei Shleifer discovered soon after Vanguard launched its first retail index fund in 1976 that adding new stocks to the S&P 500 would go up ‘relative to the rest of the market’.

In an ‘intrinsic’ market with previous predictions and theories this ‘was not supposed to happen’. He stated his paper reminded him about his rabbi speeches. This comparison was accepted by financial analysts on Wall Street.

Chapter Fifteen, Mike Jensen Changes his Mind About the Corporation changes his previous thoughts that financial markets should always set the priorities for corporations and for society as a whole. Internet companies were rapidly losing money after a long history of financial rewards. Not many investors had considered the risks only had considered the rewards. Stock internet prices had fluctuated before but only to recover but only this time they did not. This plumage again gave rise to the fact that financial theory was only as good as the theory lived up to its name or idea.

There was no intrinsic value to it. Enron and WorldCom faked their earnings and self-destructed and other companies such as Time Warner sold out to other companies. People had followed Jensen’s theories in the 1990’s stating that the government had no role in the American stock market and the Japanese were squeezing money out of our system. He now stated our economy was alright and stable and would make it out of this current situation. Doug Henwood and Thomas Frank professed that it is not the stock market that people do not trust but the high conglomerates that run it.

Chapter Sixteen, final, Gene Fama and Dick Thaler Knock Each Other Out discusses the debate over market rationality. The professors spoke rationally about how hot funds tend to cool off and how cool funds eventually turn hot again with regards to playing the stock market.

Orthodox education in finance is not the key to successful investment strategies. Often irrational investment strategies work out just the same or better. There is only one true and resolute theory, “the theory of inefficient markets”, states Merton Miller.