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The Myth of the Rational Market

The notion that financial markets know a lot has been around as long as financial markets themselves.   In 1889, stock market chronicler George Rutledge Gibson asserted that when “shares become publicly known in an open market, the value which they there acquire may be regarded as the judgment of the best intelligence concerning them.”  Hints of this same attitude could be found in the work of early economist such as Adam Smith—and even the religious thinkers of the Middle Ages.  While some medieval ecclesiastical scholars argued that lawgivers should set a “just price” for every good to guarantee that producers earned a living wage and consumers weren’t gouged, others, St. Thomas Aquinas among them, held that the just price was set by the market.

From the introduction to The Myth of the Rational Market

As I was thumbing though Justin Fox’s excellent new book this morning, The Myth of the Rational Market, it struck me that, when it comes to financial markets, there is really nothing new under the sun.  The debates being had today –capitalism vs. socialism, free markets and prices vs. “fair” markets and prices, etc. — are the same debate that our ancestors had when they crawled out of caves and began to barter animal skins with one another.  I suspect that 100 years from now, our descendants will be arguing these same points, just as passionately.

Fox has written an excellent history on the various schools of thought that can be lumped under the umbrella of market rationality.   His objective is not to criticize capitalism but rather to criticize the belief — bordering on fundamentalist religious dogma — that the market is always “right.”   Continuing the quote from above, Fox writes:

All these early claims for the correctness and justness of market prices came with caveats—doses of realism, you could call them.  George Gibson wrote that stock exchanges were prone to manias and panics and called for the regulation of “bucket shops” that urged customer to speculative excess.  Adam Smith thought corporations with widely dispersed ownership—the shares of which are what make the stock market go—were abominations.  Thomas Aquinas made no claim that the market price was always right, just that it was hard to come up with a fairer alternative.

Markets prices — be they for internet stocks in the 1990s, nondescript condos in Miami in the 2000s , or tulip bulbs in 1630s Holland — are prone to periodic bouts of wild, irrational excesses.  They are not always “right,” and trusting blindly in their wisdom generally doesn’t end well — as the meltdown of 2008 reminds us.

Again, this is not to criticize capitalism.  We are big believers around here in the free market and in the endless stream of economic miracles  it has produced.  (I voted for Ron Paul, for crying out loud.) But you have to understands its limitations, particularly in the case of the financial markets.  As the market is comprised of emotional people, it is not reasonable to believe that, collectively, these emotional people will always act rationally.   Our old friends Greed and Fear will insure that this doesn’t happen.

I find myself in agreement with Thomas Aquinas.  The market price will not always be “right,” though to date, there has never been a more effective alternative.  Unless the human race evolves into a bunch of cold, logical Vulcans like Spock, our emotions and herding instincts will prevent the market from ever being truly rational.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy