Justin Fox in his latest offering, “The Myth of the Rational Market” (pub. HarperCollins, 2010) adds to the growing library of books which attempt, in part, to explain the recent financial crisis of the past few years. Mr. Fox presents an extremely informative and well-written narrative of modern financial economics. If you read his book and take the arguments seriously, you may very well avoid the significant pitfalls which doom some investors to continued portfolio losses. On the other hand, if you think you can beat the market through shear intelligence, or cunningness, don't bother reading the book, as according to Mr. Fox you will soon be much lighter in the wallet. After reading the book, I would have to concur with his conclusion.
It helps if the reader has a basic familiarity with the Efficient Market Theory (NYSEARCA:EMT). Simply put, it is the concept that the financial markets are basically rational. It consists of two halves. The first concerns insider information. It states that unless the investor has some inside information not available to others, he simply will not be able to discern if security prices are too low or too high. The evidence in favor of this theory is overwhelming. If your broker tells you he can pick winners run, don’t walk, as fast as you can. Indeed, many feel that the best investment approach is simply to invest in low cost mutual funds (or ETFs). History has shown that you will do very well that way over the long haul. The second half of the EMT is that market imbalances will not persist for more than a very short time, because as soon as they are discovered, they will be arbitraged away. However, there is fairly strong evidence that this is often wrong; the equity market, for example, can suffer run-ups for long periods of time; everyone knows the market is out of balance, but no-one knows (or wants to be the first) to get off the bandwagon.
This book is an extremely valuable resource for the non-professional. There are very few equations, but Fox lays out the assumptions behind the theories, and what arguments and data can be presented for and against it. Financial economics is perhaps the most difficult area of economics because it uses high-powered math, including stochastic differential equations. The large amount of financial data makes it relatively easy to test financial theories, so we know fairly well what works and what doesn't. Fox does a convincing job in this area.
Justin Fox deftly brings the complex topics of efficient market theory, option models and CAPMs down to the layman's level. His research is impeccable and he highlights most of the major players; Black, Fisher, Friedman, Modigliani and Buffett, as well as a large cast of supporting players. Fox does a much better job, however, with more "modern" economic figures than with the "founding fathers". However, in both the "Early Days" and “Rise of the Rational Market" sections, I felt like the book started to overwhelm the reader with the inundation of names, places and theories. It wasn't until Fox started the "Conquest of Wall Street" section and through the conclusion of the book, that I became focused on the subject matter again. In my opinion chapters were probably those on Warren Buffett and Alan Greenspan. Fox seems to really dig into the subject of both men with a little more interest than many of the previous. I was able to satisfy my desire for details on each without feeling overwhelmed.
In my opinion, the Epilogue was the most useful and appealing part of the entire book. It was straightforward, entertaining and educational. I was able to more fully grasp what had occurred with Fannie Mae, Freddie Mac, subprime mortgages and Ponzi schemes. In the end, there are not a lot of conclusions from Mr. Fox, but none should be expected. After all, the financial markets are a fluid and ever-evolving entity. The Myth of the Rational Market is a well-presented overview on the subjects of the efficient market theory and Wall Street.