The myth of rational markets and the march of science

Anyone who has read the work of Thomas Kuhn knows that the advancement of science does not occur in a straight line. There will be the development of a new thesis that replaces old science when the old theory does not fit the facts. However, this process can be very messy.

There is empirical testing of a theory or view which will initially provide support for the theory. Unfortunately, the theory cannot explain all of the events and empirical irregularities start to exist. The original theory has to be twisted and changed to explain these events until one day there is a new theory or alternative hypothesis to replace the old. While this process is going on, careers are made and broken. Personalities will often drive the direction of the new science. Feelings will be hurt, intellectual battles will be fought and defenses of life's work will be made. The Myth of Rational Markets by Justin Fox is the story of how the theory of efficient markets has developed and been changed over the last few decades.It is a history of financial theory. It is very good at describing the personalities associated with this story. It is not about myths but how science is created.

Having lived through a good portion of this period and worked on efficient market studies, I was not surprised by this rough science and debate. Was the theory of efficient markets full of delusions? No. It was a very good starting assumption. Markets will be competitive and include all available information. It was like any theory that is put through rigorous testing. Unfortunately, the advancement in finance on efficient markets will often escape the students who have been indoctrinated by faculty in their introductory investment classes.

Efficient markets never was supposed to rule all of the decisions of investment professionals. It has served as a useful foundation, but this foundation needs new support. Markets are rational until there is a new level of uncertainty. However, we may say that it was perfectly rational for bigger mortgage bets when rates are low and there have not been previous loses in housing. Our ability to see irrationality is usually only in hindsight. Fox does a great job of telling the story of efficient markets but there is expose here. It is just the history of science.