Rational Markets Theory Keeps Running Into Irrational Humans
April 12, 2018
To many young people, the idea of efficient financial markets -- the idea that, in the words of economist Eugene Fama, “At any point in time, the actual price of a security will be a good estimate of its intrinsic value” -- probably seems like a joke. The financial crisis of 2008, the bursting of the housing bubble, and gyrations in markets from gold to Bitcoin to Chinese stocks have put paid, at least for now, to the idea that prices are guided by the steady hand of rationality. The theory won Fama an economics Nobel Prize in 2013, but he shared it with Robert Shiller, whose research poked significant holes in the idea decades ago.
But believe it or not, there was a time when efficient markets theory occupied a place of honor in the worldview of economists and financial professionals alike. This is chronicled in my colleague Justin Fox’s excellent book, “The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.” Though Fama did empirical research that seemed to support market efficiency, at its core the idea is based on fairly simple logic -- if people consistently buy assets for more than its fundamental value, they’ll lose money. If people lose money, they’ll be pushed out of the market, and only investors who tend to pay the right price -- often referred to as “rational arbitrageurs” in economics papers -- will remain. Economist Milton Friedman legendarily stated this idea in 1953 when he wrote:
“People who argue that speculation is destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when [an asset] is low in price and buy when it is high.”
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