The subprime meltdown brought the arcana of financial economics into the realm of popular discourse, as the edifice built upon its theories disintegrated. Fox takes the reader on a 100-year trip through the history of this discipline. He visits both the ivory towers where financial theories were conceived, and the markets where those theories were applied.
This is a dense subject and not easily explicable without recourse to equations and Fox has eschewed all maths. Instead, this necessarily simplified exposition is leavened by entertaining descriptions of the people who played prominent roles in the evolution of finance.
The first character to be introduced is pioneering mathematical economist Irving Fisher. Fisher contributed a lot, both before and after he made himself infamous by declaring stocks had reached a permanent high plateau, a fortnight before the Wall Street Crash of 1929.
Luminaries like Friedman, Fama, Markowitz, Modigliani, Merton Miller, Kenneth Arrow, Michael Jensen, Myron Scholes, Fischer Black, Jack Treynor, William Sharpe, etc. all appear onstage as well. There are also cameos from legends like Paul Samuelson, Keynes, John Von Neumann, Stiglitz, Mandelbrot, etc.
Fox combines pen-sketches of economists who investigated markets, with explanations of the theories each spawned, or modified. He also introduces behaviourists like Thaler, Twersky and Danny Kahneman, whose findings challenged the basic axioms of finance. Along the way, he describes more conventional attacks authored by Shiller, Summer, and even by Fama himself.
The axioms underlying financial economics are rationality and equilibrium. It is axiomatic that human beings are rational creatures. It is also axiomatic that equilibrium is quickly reached in any freely traded market where supply must match demand.
Starting from those foundational axioms, vastly impressive logical edifices can be built. The efficient market hypothesis (EMH) is the most pervasive of these. The EMH assumes, given free symmetric information dissemination and low-friction trading mechanisms, rational investors will quickly discount all price-sensitive information. Hence, prices will wander randomly close to intrinsic value, whatever “intrinsic value” may be. In such efficient markets, it is impossible for anybody to consistently generate extraordinary returns, except by pure chance. Even if imperfections arise, they are quickly arbitraged. Also, assuming rationality and equilibrium, intrinsic value can be calculated through comparison to risk-free assets; risks can be assessed, optimal strategies worked out.
It’s a very logical structure. If price changes are random, they should conform to the tractable normal distribution. In a classic bell curved normal distribution, 68.2 per cent of price changes fall within one standard deviation (SD) of the average, 95 per cent will be within two SD of average and 99.6 per cent within three SD, etc.
Risk can be quantified by tying it to variance, covariance and standard deviation. Portfolios can be built by assessing correlation, so as to diversify and reduce risk while optimising return. The additional complications introduced by leverage, margin, etc. can also be crunched out.
But are the basic premises true? In 1931, Kurt Godel proved that any logical system depends upon axioms that cannot be proved (or disproved) within that system. The Incompleteness Theorem has implications for anything that relies on the certitude of mathematics, including finance.
Are investors truly rational? Does financial trading in aggregate quickly arbitrage all imperfections till equilibrium is reached? If these axioms are not true, it is difficult, if not impossible, to calculate intrinsic value, or to assert that random price movement doesn’t contain more complex patterns.
The EMH or random walk theory, as it is sometimes called, has led to the development of successful strategies such as index-investing. There is a lot of evidence indicating markets are efficient much of the time. But it has also become evident that price changes are not absolutely random.
Sometimes, prices move a long way beyond rational and these extreme events occur far more often than the EMH predicts. The distribution of price change is a very long-tailed version of the normal distribution. Nobelists like Merton and Scholes of LCTM lost enormous sums because tiny flaws in theory turned into huge drawdowns in practice, when magnified by leverage.
Robert Shiller called the EMH “the most remarkable error in the history of economic theory”. Stiglitz proved perfectly efficient markets couldn’t exist. Trader-investors like Warren Buffett, Peter Lynch, Ed Seykota, et al, have, over decades, consistently and systematically generated “impossible” returns. Behaviourists have showed that the majority of investors are not rational.
Yet, the market is rational most of the time and beating it is difficult. We also lack means of reliably predicting when the equivalent of a financial hissy fit is imminent. The bubble of 2006-08 and earlier bubbles and depressions collectively demonstrate that, when imperfections arise, they can persist for much longer and in far greater magnitude than the EMH predicts they should.
As Keynes reputedly said, “The market can stay irrational for longer than you can remain solvent.” Slavishly following the EMH and implementing the strategies that arise logically from it, can cause absolute disaster when the market is not rational. If all the major market participants implement “rational” strategies, the amplitude of the disaster may even increase.
This book isn’t just a pop history of financial theory. It offers a basic understanding of the financial landscape of the past and present, and probably of the future. Despite the lack of maths, or perhaps because of that very lack, a reader can internalise the message: markets and the people who operate them aren’t always rational. That understanding may not help you beat the street but it could save your skin.
THE MYTH OF THE RATIONAL MARKET
A History of Risk, Reward and Delusion on Wall Street
Justin Fox
Vision Books
382 pages; Rs 895
