5 Key Takeaways from The Myth of the Rational Market
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Last year my Dad issued a challenge for me to start reading investment books. After completing 4 books last year, the challenge is back with a new list of books this year.
The first book on the list is “The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street,” by Justin Fox.
Fox published this book in 2011, looking back at the market crash of 2008. In many ways, it acts as both a history and economics lesson. Fox goes into detail of the history of the earliest days of Wall Street all the way through the circumstances that led to the financial crisis.
Here are the key takeaways I had:
1. Efficient Market Hypothesis
The premise of the book centers around the efficient market hypothesis. The efficient market hypothesis is one of the world’s most influential investment theories, stating “that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.” (Investopedia)
The efficient market hypothesis was dreamed up by Eugene Fama in the late 1960s. He envisioned a market in which “security prices at any time ‘fully reflect’ all available information.” Essentially this theory is saying the market is rational and that investors aren’t able to beat the market because it’s already priced perfectly.
This line of thinking lasted for decades, where it was assumed that security prices reflected all available information and the markets weren’t subject to bubbles or panics. This has clearly proven to not be the case, as we saw in the dot-com bubble from 1997-2001 and the 2008 housing crash.
2. Financial markets aren’t rational
The efficient market hypothesis leads directly to the myth of the rational market, which is the belief that financial markets can be relied upon to get things right. This was a widely held belief throughout much of history, but the belief turned out to be wrong.
The biggest takeaway from the book can be summed up succinctly: financial markets possess many wonderful traits, but that rationality is not always among them. Relying on markets to be right all the time can be a very dangerous thing to do. Financial markets don’t know everything. They know a lot and the signals they send shouldn’t be ignored, but all decisions can’t be left up to the market. We, as investors, need to do our own research and make our own decisions.
Fox says, “the theory holds that the decisions of millions of investors, all digging for information and striving for an edge, inevitably add up to rational, perfect markets. That belief has crumbled.”
Although it’s not perfectly rational all the time, Fox explains the stock market processes information quickly and is able to handle both good news and bad news in an orderly fashion (for the most part). This means that getting an edge is extremely difficult and any news surrounding a company gets incorporated into the stock price right away.
The last few market drops since the late 1980’s have taken a multiple years to recover. Here’s a great walk-through from Zach at Four Pillar Freedom that shows how long it took the S&P 500 to recover from various drops throughout the years.
3. Humans aren’t rational either
The market isn’t rational, but neither are humans. Fox explains: “The Efficient Markets Hypothesis fails because humans are herd animals, not independent rational actors. Thus the best investors tend to be antisocial and contrarian.”
Humans have a tendency to practice herd behavior, which means we follow the crowd. If everyone is talking about a hot stock, we’re more likely to think it’s a good investment. This leads to some companies getting priced too high and some companies falling out of favor with the market and being priced too low.
4. Sometimes the best companies are the worst stocks
A surprising lesson I learned, is that sometimes the best companies are the worst stocks. It sounds almost counterintuitive, but with a deeper look it makes sense. Expectations can become way too high, where future growth is already reflected into the current stock price, leaving little margin of safety for the investor.
For example, I’ve seen Apple announce record quarters and then have their stock price drop. This never made sense to me, but this is the principle in action. Expectations for some companies are so high that no matter how fast they grow, they may not reach them.
5. Another vote of support for value investing
Fox voices his support for value investing: “For those with more time and perseverance than I possess, the big lesson from the fall of rational market theory is that value investing works—but it works in large part because it’s very hard to stick to.”
Value investing “is a method of investing where stocks are selected that trade for less than their intrinsic values. Value investors actively seek stocks they believe the market has undervalued.” (Investopedia) Benjamin Graham talks about this method of investing in detail in his book, The Intelligent Investor.
We’ve learned that the markets aren’t always rational, meaning sometimes prices are too high or too low. This means there are still opportunities out there for value investors.
Investors need to be focused on finding value and doing their own research, rather than buying into the hype and sensationalism found in the media. Intelligent investors look beyond the share price and focus on a company’s true value. Graham advises to buy and hold for the long-term rather than reacting to market swings. Fox is in agreement with Graham.
Final Thoughts
Overall this was an interesting read. The fact that the book offered a historical perspective, yet centered around a market crash that we’ve all lived through was eye-opening. It also cleared up a lot of thoughts I had about how the market prices certain stocks. It’s important to keep in mind that the market is not rational, which means that there is still opportunity out there.
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