New Book: Myth of the Rational Market by Justin Fox

[Random Walker]

Just started a new book and it looks very good. It is called "The Myth of the Rational Market" by Justin Fox. It is basically a history of the development of the efficient market hypothesis. I'm only about 40 pages into the 300+ pages, but it looks excellent. As you can tell from the title word "MYTH", the author sees major flaws in EMH. I actually think though that the book is very much a Boglehead book. I think he somewhat confuses "rational" and "efficient", but his text is very clear and a reader tuned into this distinction can learn quite a bit and engrain some important beliefs about how markets work. I think the author assumes the strongest form of EMH and that is why he uses the word "myth". But the reader may come out of the book with a strong appreciation of a somewhat less stringet form of EMH.
The book starts in the late 1800's and describes the history of finance with all the big names this board appreciates. There are chapters dedicated to Markowitz, Samuelson, Fama, Bogle, Thaler, Shiller.
Just 15 pages into the book there is an excellent quote from Irving Fisher that very succinctly shows how an efficient market can become irrational quickly when everyone begins to think alike: "Were it true that each speculator made up his mind independently of every other as to the future course of events, the errors of some would probably be offset by those of others. But, as a matter of fact, the mistakes of the common herd are usually in the same direction. Like sheep, they all follow a single leader."
I'm only about 10-15% into the book, but I think it is going to be very good. I recommend it. Curious to hear if others have read it and what they think.

Dave

[cjking]

Sounds good, but costs roughly $55 second-hand on amazon.co.uk - I will have to wait a while. Or, seeing that it's available for $17 in the US, I should buy it from there and resell it here, making the UK price more rational.

Ironically, when I went to the Financial Times to check the exchange rate so I could quote that price in dollars, I found the following article.

A new realisation has dawned among the most fervent advocates of financial analysis and collective investor wisdom – markets are not always rational.

http://www.ft.com/cms/s/0/4a51fc5c-59cc ... abdc0.html

[LoopyGinJuice]

Haha. Does 60+ years old count as "new"?

http://www.quotationspage.com/quote/38206.html

[Random Walker]

That quote I copied from the book above was written in 1905! As Larry says " the only new things in investing is the history you haven't read yet" (or something to that effect). I think reading financial history builds the fortitude to handle bears and the calm to not get carried away in bull markets.

Dave

[larryswedroe]

I just finished it and would highly recommend it, but not for beginners, not a dummies book
Good "expose" of the debate about markets being efficient or not and rational or not
Basically comes down to this, markets may not be perfectly efficient and they are not always rational but investors are almost certainly best off acting as if they were-invest in index funds, not active funds

[bob90245]

Is Warren Buffett cited as proof that the market is not efficient? That's the standard claim from those taking the other side of the debate.

[Random Walker]

Just took a quick look in the index. He's mentioned lots in the book. There's a chapter titled " Beating the Market with Warren Buffet and Ed Thorp". One paragraph starts out " Buffett's success had begun to cause head-scratching among finance professors long before ____".

Dave

[bob90245]

Just took a quick look in the index. He's mentioned lots in the book. There's a chapter titled " Beating the Market with Warren Buffet and Ed Thorp". One paragraph starts out " Buffett's success had begun to cause head-scratching among finance professors long before ____".

Dave

Now how did I know that! :roll:

What they don't tell you is how to find the next Warren Buffett so we can all get rich!

[Rick Ferri]

As far as 99.9% of individual investors are concerned, the markets are super-efficient. The only myth is that more than 0.1% of individuals will beat the market though genuine investment skill. Perhaps more people will get lucky, like hitting the lottery, but that is not skill because they don't know how they did it and cannot repeat the performance.

Rick Ferri

[Taylor Larimore]

Hi Dave:

Your words of wisdom deserve repeating:

"Reading financial history builds the fortitude to handle bears and the calm to not get carried away in bull markets."

Thank you.

[tetractys]

Thanks for pointing out the book. Just put it on hold at my local library. They have 5 copies and I'm 35th in line, so it looks like it's pretty popular.

I'm all for the compiling of financial history. It's fascinating that even though human nature is the prime foundation of financial markets, we still have very little understanding of the whole mechanism. I surmise the basic efficiencies and premiums of all markets since written history began haven't changed at all in principal, and it will take a better understanding of that to advance market theory, and perhaps simplify it as well.

And I totally agree with you folks above that knowing financial history makes us better investors. It certainly alleviates fear and greed--"Knowledge is power."

Best regards, Tet

[madsinger]

NPR's "Marketplace" had an interview with Justin Fox on today's show:

http://marketplace.publicradio.org/disp ... _market_q/

Read or listen, your choice!

-Brad.

[mudfud]

Thanks for the suggestion, I'm #4 in the hold queue at my library. Look forward to reading it.

[cjking]

Here's a Financial Times review.

http://www.ft.com/cms/s/2/08bc21d8-5395 ... abdc0.html

The following from the review would have stirred up a few recent EMH discussions.

More startling is Fox’s story of the University of Chicago’s Eugene Fama, who promulgated the efficient markets hypothesis in its most widely recognised form by combining it with the capital asset pricing model that portrays investing as a trade-off between risk and return. The key risk, known in the jargon as beta, is the sensitivity of a stock’s price to moves in the market as a whole. According to Fama’s theory, movements in stocks are random, except that high-beta stocks will be more volatile.

But in the early 1990s, Fama and Kenneth French published a large empirical survey of stock market returns since 1940 and found several ways in which returns were not random and which could not be explained by beta. In aggregate, smaller companies did better than larger ones, while “value” stocks, which are cheap compared with the book value on their balance sheet, also outperformed. There was even a “momentum” effect – stocks that had been doing well for a while tended to continue to do so.

Fox makes clear that this was tantamount to the founder of efficient markets admitting his theory was wrong and quotes the judgment of one critic: “The Pope said God was dead.” He is also scathing about Fama’s attempt to rescue the theory by categorising all these effects as “risk factors”. For example, a cheap company with a high price-to-book value was risky, and hence it generated higher returns for its investors. “This amounted to saying that the same company was a riskier investment at $5 a share than at $20 – a bizarre contradiction of the teaching of successful investors.”

[cjking]

The Time magazine review is much longer and better. I'm still reading it, but I liked this:-

Samuelson's nephew Lawrence Summers demonstrated that it was impossible (without a thousand years of data) to tell a rationally random market from an irrational one.

http://www.time.com/time/magazine/artic ... 53,00.html

(Edit: Actually it's not a review, it's an article by the author.)

[Adrian Nenu]

Beating some benchmark is irrelevant, efficient market or not; the risk an investor takes to achieve specific goals is what counts.

Adrian
anenu@tampabay.rr.com

[tadamsmar]

The Time magazine review is much longer and better. I'm still reading it, but I liked this:-

Samuelson's nephew Lawrence Summers demonstrated that it was impossible (without a thousand years of data) to tell a rationally random market from an irrational one.

http://www.time.com/time/magazine/artic ... 53,00.html

(Edit: Actually it's not a review, it's an article by the author.)

Larry Summers seems to contradict himself. He is quoted as saying that 1000 years of data would be needed to prove the market was inefficient. Then he is quoted as saying a single day in 1987 proved it.

[cjking]

The Time magazine review is much longer and better. I'm still reading it, but I liked this:-

Samuelson's nephew Lawrence Summers demonstrated that it was impossible (without a thousand years of data) to tell a rationally random market from an irrational one.

http://www.time.com/time/magazine/artic ... 53,00.html

(Edit: Actually it's not a review, it's an article by the author.)

Larry Summers seems to contradict himself. He is quoted as saying that 1000 years of data would be needed to prove the market was inefficient. Then he is quoted as saying a single day in 1987 proved it.

Both could be true, if you vary the target audience. 1987 is enough to convince me that, if markets are mostly unpredictable, it's not because they always rationally summarise fundamental information, but at times because they summarise chaotic crowd behaviour. A thousand years of data is what it will take to convince those on this forum who currently believe the market price is always "right."

[TnGuy]

Burton Malkiel's review of the book in the Wall Street Journal


David

[cjking]

Burton Malkiel's review of the book in the Wall Street Journal

In that review, he says

Efficiency does not mean that prices are always correct, but when they are not, they adjust rather quickly. A less extreme efficient-markets theory, then, posits that there are no persistent arbitrage opportunities. By that definition, the rational market is not a myth.

He's trying to redefine "rational." He's saying that if you can't make an arbitrage profit, the price is rational. But what if, as at end 1998, you can increase your expected return by switching from equities to a far safer asset, TIPS? That's not arbitrage, but it shows equity prices are irrational.

The fact there are no arbitrage profits to be made does not mean prices are rational, as arbitrage is not the only beneficial response one can make to mispricing.

I contend that the price of the S&P 500 was nearly three times fair value at the 2000 peak, and that it spent much of two decades being "wrong", as it approached and departed from that peak. I agree there was no way to exploit this by arbitrage, but I'm not willing to call those prices rational.

[nisiprius]

Always keep in mind that if the market is pretty efficient, then 99% of everyone in the finance industry has nothing to write about, nothing to sell, and no need to be working in the job they're working in.

There's a huge motivation for looking for and seizing on every scrap of evidence to the contrary.

[superlight]

Remember that "efficiency" without "rationality" is of limited use. It just means that the market flows easily and unpredictably to unusual destinations. Yes, broad index funds and long hold times are one protection we can manage, but without rationality we need to be wary even of them.

[TheEternalVortex]

He's trying to redefine "rational." He's saying that if you can't make an arbitrage profit, the price is rational. But what if, as at end 1998, you can increase your expected return by switching from equities to a far safer asset, TIPS? That's not arbitrage, but it shows equity prices are irrational.

No it doesn't, because you don't have future knowledge in 1998. So the fact that equities reflect low returns over the next 10 years doesn't mean they are inefficient.

The fact there are no arbitrage profits to be made does not mean prices are rational, as arbitrage is not the only beneficial response one can make to mispricing.

True, but no arbitrage profits is a necessary condition for prices to be rational.

I contend that the price of the S&P 500 was nearly three times fair value at the 2000 peak, and that it spent much of two decades being "wrong", as it approached and departed from that peak. I agree there was no way to exploit this by arbitrage, but I'm not willing to call those prices rational.

How do you know it was "three times fair value"? Only because it subsequently dropped? That's meaningless. If I have a lottery ticket, what is it's "fair value"? Maybe $1? But after the results are known that value could be markedly different. Does that mean it was mispriced at the time?

[TheEternalVortex]

Maybe we should agree on a definition of "rational market"?

[DartThrower]

I just finished it and would highly recommend it, but not for beginners, not a dummies book
Good "expose" of the debate about markets being efficient or not and rational or not
Basically comes down to this, markets may not be perfectly efficient and they are not always rational but investors are almost certainly best off acting as if they were-invest in index funds, not active funds

Awwww, you gave away the ending! lol

It seems to come to similar conclusions as Mandelbrot in his "Misbehavior of Markets" book, only Mandelbrot likes to use his chaos theory-type approach. It's interesting how these books can be less popular since they don't give easy cut-and-dry answers.

[saurabhec]

How do you know it was "three times fair value"? Only because it subsequently dropped? That's meaningless. If I have a lottery ticket, what is it's "fair value"? Maybe $1? But after the results are known that value could be markedly different. Does that mean it was mispriced at the time?

Are you sure your real name is not Eugene Fama As Thaler said of him, Fama "is the only guy who who doesn't think there was a bubble in Nasdaq in 2000". I am actually a believer in EMH as the theory that best explains empiricial data, but I do believe that bubbles can form in markets, and do not believe that the markets are always correctly priced. Most of the time yes, but sometimes mania takes over. I think it is perfectly acceptable to reduce equity exposure at such times even if it is tarred with the scarlet letter of being a "timer". It was sad to read Fama in 1999/2000 in Fortune magazine when he was asked about the stratospheric valuations of Yahoo, AOL etc and he responded that investors were probably expecting a low return going forward, when I think one would be hard-pressed to find a single Yahoo or AOL investor who expected returns to be anything short of stratospheric.

[cjking]

He's trying to redefine "rational." He's saying that if you can't make an arbitrage profit, the price is rational. But what if, as at end 1998, you can increase your expected return by switching from equities to a far safer asset, TIPS? That's not arbitrage, but it shows equity prices are irrational.

No it doesn't, because you don't have future knowledge in 1998. So the fact that equities reflect low returns over the next 10 years doesn't mean they are inefficient.

Using 1/PE10 as a predictor, I could have predicted equity real returns of 2.6% on equities bought at end 1998 prices and held for a long time.

There are other methods I could have used that would have given roughly similar predictions.

In other words, I do claim I can predict the future return of the S&P 500, where by future return I mean the average annual return to a range of different potential selling dates, extending very far into the future. One cannot predict to a single selling date because of short-term volatility that affects the selling price. (Not just short-term volatilty - one needs to average out longer periods of over/undervaluation as well.)

(I know these are contentious claims, but they are documented with reasons in previous threads I've been involved in, so I'm not elaborating to much here.)

(In one of the other threads I posted in today, I documented using a Monte Carlo simulation to test a withdrawal strategy over the whole period that PE10 data is available for. At the beginning of the 128 year period, PE10 predicted returns of 5.4%, at the end of the 128 years the historical return was 5.8%. Pretty close. Of course it's a helpful co-incidence that the market was roughly at fair value on the end-date, if it had been up or down a lot then one would have had to take the average selling value over a number of years surrounding the end-date to eliminate shorter-term randomness from the selling price, and get a measure of the markets trend value to measure the prediction against.)

(Having made provocatively bold claims above, I will admit that the long timescales these predictions work on and the flexibility required with regard to selling dates probably reduce their usefulness to many investors.)

The fact there are no arbitrage profits to be made does not mean prices are rational, as arbitrage is not the only beneficial response one can make to mispricing.

True, but no arbitrage profits is a necessary condition for prices to be rational.

I contend that the price of the S&P 500 was nearly three times fair value at the 2000 peak, and that it spent much of two decades being "wrong", as it approached and departed from that peak. I agree there was no way to exploit this by arbitrage, but I'm not willing to call those prices rational.

How do you know it was "three times fair value"? Only because it subsequently dropped?

No. The book "Valuing Wall Street" explains why the "q" ratio is the correct way to value markets. "q" is the price of the market divided by the replacement cost of all the companies assets. When these two numbers get out of line, economic logic says that arbitrage must eventually cause them to correct. Historically correction has happened. The spreadsheet where I keep my data shows that the index was priced at 294% of the replacement costs of its constituents assets, in October 2000.

As an alternative measure, 1/PE10 was predicting a return of 2.3% in October 2000. People use a range of figures for the long-term return on shares, 6.7% used to be the most common one. 6.7%/2.3% = 291% overvaluation. Fairly consistent with what "q" was saying.

[bob90245]

Using 1/PE10 as a predictor, I could have predicted equity real returns of 2.6% on equities bought at end 2008 prices and held for a long time.

Wasn't P/E10 at the end of 2008 somewhere around 15? (Click HERE) If so, your long-term prediction of 2.6% real return seems kinda low.


Source: http://bobsfiles.home.att.net/OddsAndEn ... #RetVsPE10



Edit2: Added link to Shiller's P/E10 spreadsheet

Edit3: Added clarification

[DartThrower]

I think one would be hard-pressed to find a single Yahoo or AOL investor who expected returns to be anything short of stratospheric.

My take is that most new Yahoo and AOL investors by 1999 simply thought they could get out before the music stopped. In other words it was not about the prices having anything to do with underlying value or expected future returns, but rather it degenerated into pure speculation on the optimism of other investors. People who rebalanced prudently year after year leading up to 2000 had a natural escape hatch from this.

There is amazing irony in all this in the sense that people who feel they can beat the market due to its inefficiency create the very environment in which the people without such temerity actually do beat most of them, in the fullness of time.

[cjking]

Wasn't P/E10 at the end of 2008 somewhere around 15? (Click HERE) If so, your long-term prediction of 2.6% real return seems kinda low.

I meant to say 1998, not 2008. I've corrected my post, thanks.

(My prediction for at end-2008, though not relevant, would have been 1/15.37 = 6.5%.)

[tadamsmar]

Burton Malkiel's review of the book in the Wall Street Journal

In that review, he says

Efficiency does not mean that prices are always correct, but when they are not, they adjust rather quickly. A less extreme efficient-markets theory, then, posits that there are no persistent arbitrage opportunities. By that definition, the rational market is not a myth.

He's trying to redefine "rational." He's saying that if you can't make an arbitrage profit, the price is rational. But what if, as at end 1998, you can increase your expected return by switching from equities to a far safer asset, TIPS? That's not arbitrage, but it shows equity prices are irrational.

The fact there are no arbitrage profits to be made does not mean prices are rational, as arbitrage is not the only beneficial response one can make to mispricing.

I contend that the price of the S&P 500 was nearly three times fair value at the 2000 peak, and that it spent much of two decades being "wrong", as it approached and departed from that peak. I agree there was no way to exploit this by arbitrage, but I'm not willing to call those prices rational.

Last I checked, you don't get fair value (whatever that is) when you sell a stock, instead you are paid the market price. You seem to be unaware of this fact.

I would have been irrational to sell out in 1998. It was rational to assume the bull market run would continue for a while and that there was plenty of profits on the table to be had by selling out later.

[saurabhec]

I would have been irrational to sell out in 1998. It was rational to assume the bull market run would continue for a while and that there was plenty of profits on the table to be had by selling out later.

What you are saying contradicts EMH. You are simply saying that you can time when to sell better. A more consistent approach would be to either go the Fama route and basically say that there are no irrational bubbles. If you are simply comparing 1998 vs 2000, then that is a difference of opinion of when a bubble would burst, not a fundamental difference in approach from what the OP said.

[cjking]

Burton Malkiel's review of the book in the Wall Street Journal

In that review, he says

Efficiency does not mean that prices are always correct, but when they are not, they adjust rather quickly. A less extreme efficient-markets theory, then, posits that there are no persistent arbitrage opportunities. By that definition, the rational market is not a myth.

He's trying to redefine "rational." He's saying that if you can't make an arbitrage profit, the price is rational. But what if, as at end 1998, you can increase your expected return by switching from equities to a far safer asset, TIPS? That's not arbitrage, but it shows equity prices are irrational.

The fact there are no arbitrage profits to be made does not mean prices are rational, as arbitrage is not the only beneficial response one can make to mispricing.

I contend that the price of the S&P 500 was nearly three times fair value at the 2000 peak, and that it spent much of two decades being "wrong", as it approached and departed from that peak. I agree there was no way to exploit this by arbitrage, but I'm not willing to call those prices rational.

Last I checked, you don't get fair value (whatever that is) when you sell a stock, instead you are paid the market price. You seem to be unaware of this fact.

I would have been irrational to sell out in 1998. It was rational to assume the bull market run would continue for a while and that there was plenty of profits on the table to be had by selling out later.

It's a valid point that you may not be able to sell at fair value if you have no flexibility about your selling date.

Even with a lot of flexibility you might only be able to get closer to it.

I allow five years flexibility in another thread on withdrawal strategies, where the sale proceeds are required to fund one years income, also the strategy locks in returns when they've achieved an annualised rate 20% below that predicted. These safety mechanisms reduce the obtainable return below the predicted one.

With regard to your second point, I would say at any given time I have no idea what is going to happen in the short term, say periods of less than ten years, I only claim to have an idea of what's going to happen over the next 40, and even then, only on average, not to a particular end date. For me, if I were a US investor in 1998, the yield on property (probably) or TIPS (definitely) would have been more attractive than the predicted returns on shares. (I don't know what the yield on property was, I'm assuming it was within the normal range.)

[Rodc]

Using 1/PE10 as a predictor, I could have predicted equity real returns of 2.6% on equities bought at end 2008 prices and held for a long time.

Wasn't P/E10 at the end of 2008 somewhere around 15? (Click HERE) If so, your long-term prediction of 2.6% real return seems kinda low.


Source: http://bobsfiles.home.att.net/OddsAndEn ... #RetVsPE10



Edit2: Added link to Shiller's P/E10 spreadsheet

Edit3: Added clarification

I pulled the linear regression coef from your graphs and the June PE10 from the Shiller sheet, and for both 15 years and 20 years I get 5.85% real return going forward in each case, 15 years and 20 years. Interesting in part because while the regression equations are somewhat different, in both cases they gave return estimates that agree to three digits!

I'd accept ~6% real return over the next 15 years on my stock holdings.

(I have no clue what in fact I'll get)

[tadamsmar]

Using 1/PE10 as a predictor, I could have predicted equity real returns of 2.6% on equities bought at end 2008 prices and held for a long time.

Wasn't P/E10 at the end of 2008 somewhere around 15? (Click HERE) If so, your long-term prediction of 2.6% real return seems kinda low.


Source: http://bobsfiles.home.att.net/OddsAndEn ... #RetVsPE10



Edit2: Added link to Shiller's P/E10 spreadsheet

Edit3: Added clarification

I pulled the linear regression coef from your graphs and the June PE10 from the Shiller sheet, and for both 15 years and 20 years I get 5.85% real return going forward in each case, 15 years and 20 years. Interesting in part because while the regression equations are somewhat different, in both cases they gave return estimates that agree to three digits!

I'd accept ~6% real return over the next 15 years on my stock holdings.

(I have no clue what in fact I'll get)

Is this just the historical US Market?

That's a biased sample of markets.

[Rodc]

Using 1/PE10 as a predictor, I could have predicted equity real returns of 2.6% on equities bought at end 2008 prices and held for a long time.

Wasn't P/E10 at the end of 2008 somewhere around 15? (Click HERE) If so, your long-term prediction of 2.6% real return seems kinda low.


Source: http://bobsfiles.home.att.net/OddsAndEn ... #RetVsPE10



Edit2: Added link to Shiller's P/E10 spreadsheet

Edit3: Added clarification

I pulled the linear regression coef from your graphs and the June PE10 from the Shiller sheet, and for both 15 years and 20 years I get 5.85% real return going forward in each case, 15 years and 20 years. Interesting in part because while the regression equations are somewhat different, in both cases they gave return estimates that agree to three digits!

I'd accept ~6% real return over the next 15 years on my stock holdings.

(I have no clue what in fact I'll get)

Is this just the historical US Market?

That's a biased sample of markets.

Yep. Give me more data and I'll do more silly calculations.

[bob90245]

Is this just the historical US Market?

As far as I know, Robert Shiller only has historical data for the US Market. Again, here is his link:

http://www.econ.yale.edu/~shiller/data.htm

[knowmad]

Maybe we should agree on a definition of "rational market"?

Maybe we should agree on a definition of "rational".

[Chas]

As far as 99.9% of individual investors are concerned, the markets are super-efficient. The only myth is that more than 0.1% of individuals will beat the market though genuine investment skill. Perhaps more people will get lucky, like hitting the lottery, but that is not skill because they don't know how they did it and cannot repeat the performance.

Rick Ferri

How many people have founded multibillion dollar investment companies based on the assertion that they have experts and computational power that can forcast and/or beat the market? The latest are those that convinced everyone (most importantly the US government who wanted to be fooled) that housing finance was so solidly analyzed and controlled that a leverage of 50:1 or greater was perfectly safe?

[Chas]

Anyone that could ever claim that the equities market is "rational" is either a fool or else they are using some tortured definition of rational. I simply can't understand all the conversation over this. It makes me think of the old theological argument over how many angels can dance on the head of a pin. What am I missing here?

[Rick Ferri]

What you missing is the performance of active managers verses the 'irrational' market. If the market is not priced rationally, and it is easy to tell when and where is it being irrational, then why are there not more active managers outperforming the market? Are the active managers just to dumb to figure this out.

Let's say active managers are smart people. And let's say that these smart people have great difficulty beating the market. That makes a very week case for someone who is trying to argue that the market irrational.

Rick Ferri

[cjking]

What you missing is the performance of active managers verses the 'irrational' market. If the market is not priced rationally, and it is easy to tell when and where is it being irrational, then why are there not more active managers outperforming the market? Are the active managers just to dumb to figure this out.

Let's say active managers are smart people. And let's say that these smart people have great difficulty beating the market. That makes a very week case for someone who is trying to argue that the market irrational.

Rick Ferri

I think you (and many others) are, like Malkiel in his review, defining "rational" to narrowly.

I agree active managers can't outperform, I agree I shouldn't try to pick securities or managers, I agree it's not sensible to try and profit by trading on any prediction of a turning point.

I don't agree prices are always rational. I don't agree irrationality implies predictability.

For all the things I agree with to be true, all that is required is that price be mostly unpredictable over periods of several years.

EMH is sometimes interpreted as saying unpredictability stems from information that should affect the price, fundamental information, being incorporated before you can trade. This kind of price is rational and unpredictable.

An alternative explanation is that, sometimes, the price is determined by crowd behaviour, which has both predictable and unpredictable components. At these times the price may be irrational, but the unpredictable component of crowd behaviour means it's still unpredictable. You can't make easy profits on the fundamentals reasserting themselves, because you don't know when that's going to happen.

Many people seem to have so equated rational unpredictability with EMH that when someone says prices can be irrational, they wrongly assume they are rejecting unpredictability, and all the investment rules that are a consequence of unpredictability.

Most of the time the difference between rational and irrational unpredictability don't matter, but there are times when they do, such as at the peak of a bubble. For a believer in irrational unpredictability, the choice is not just between active and passive, there's a third option, neither: this asset class does not offer acceptable prospects at this time.

Another way to look at this is in terms of timeframe. It's random what the the S&P 500 is going to do over the next day/month/year, but predictable how it will perform on average over the next 40 years. So a price can be unpredictable on one timeframe while simultaneously being predictable on a much longer one.

The person buying on a one year view and the person buying on the basis of long term value pay the same price. If the price is irrational on a long-term view, then it must be irrational on a short-term one, even though it's not possible to make easy profits by betting against it.

[alec]

I'm going with Samuelson on micro efficiency vs. macro efficiency. From his 1994 paper in the Journal of Portfolio Management, The Long Term Case for Equities: And how it can be oversold.

I have considerable belief in microefficiency of liquid organized markets. I am doubtful about any great macroefficiency. General Motors' stock gets priced before and after dividend payments to preclude easy pickings. GM convertibles sell about right in ratio to GM common and GM preferred. (For a small firm, followed by few investors, I'd have to modify this plug for microefficiency.)

Why the shouldn't I believe that the level of the whole equity index gets priced right in good times and bad? The difference is that when Franco Modigliani sees a mispricing of GM common and preferred, he and others can make profits doing what corrects that discrepancy. And that's why the microefficiency gets wiped out as soon as it becomes significant enough to become recognizable.

How does the story run when, in the late 1970's Professor Modigliani opined that the Dow was below 1,000 "irrationally," in the sense that be believed it would be at least 1,400 if investors and speculator understood how not to double count the bad effects on corporations of then-current inflation? All he could do was write about it. Arguing with the tape by selling the general index short could be costly, and in any case ineffective, while animal spirits were what they were and analysts' shortcomings were what they were.

That is why I stand with Shiller (1986) as a doubter of market macroefficiency.

Caveat: I suspect that macro-mispricings will, as Japan during the period 1987-1992, create some tension toward correction. Therefore, I would expect a kind of bounded degree of macro-efficiency to prevail most of the time in the long run. Although I personally am cautious in trying to "time," when Tobin's Q wanders too far from its historic haunts, I find myself making modest changes in degree of equity exposure. Who's being human now?

[Chas]

What you missing is the performance of active managers verses the 'irrational' market. If the market is not priced rationally, and it is easy to tell when and where is it being irrational, then why are there not more active managers outperforming the market? Are the active managers just to dumb to figure this out.

Let's say active managers are smart people. And let's say that these smart people have great difficulty beating the market. That makes a very week case for someone who is trying to argue that the market irrational.

Rick Ferri

Hi Rick,

Many, many, people knew the dot.com market was irrational, likewise the Dutch tulip market, and more lately, the housing market. So how did the rational fund managers get rich from this? It looks to me as though everybody gets it when the stuff finally hits the fan. If one cuts and runs they are committing the sin of "market timing", if they buy more, thinking the top is not yet arrived they are committing the sin of market timing. If they just sit there like a deer in the headlights they are road kill. :roll:

[Rick Ferri]

I understand that arguments about irrationality, but even if one believes that markets are irrational, should that influence how you invest in the markets? Is it profitable to assume the markets are irrational? I do not believe it is. If you invest as though the market are irrational, then by default your are following some type of active management strategy, that is likely to result in lower returns than if you invest using a passive strategy of index funds.

To me, this is the only question people should be asking because it is the only relevant one, i.e. the only question that affects your net worth.

Rick Ferri

[ziggy29]

I believe that the markets ARE inefficient -- sometimes wildly so -- in the short term. In the much longer term, you can usually bet that market performance will pretty well move in high correlation with earnings growth.

So unless you're going to play a short-term game which produces more losers than winners, for long-term holding periods the short term inefficiencies become more irrelevant, particularly if you're dollar cost averaging in over several decades.

[saurabhec]

I understand that arguments about irrationality, but even if one believes that markets are irrational, should that influence how you invest in the markets? Is it profitable to assume the markets are irrational? I do not believe it is. If you invest as though the market are irrational, then by default your are following some type of active management strategy, that is likely to result in lower returns than if you invest using a passive strategy of index funds.

To me, this is the only question people should be asking because it is the only relevant one, i.e. the only question that affects your net worth.

Rick Ferri

Rick,

While I agree in most cases it will not be profitable for retail investors to consider the markets rationality or lack thereof, I do think that bubbles are a special case. By definition an investor is unlikely to encounter more than 2 or maybe 3 bubbles in their life-time. I made a decision to sit out of the equity market entirely at the end of 1998 and I am glad I did. I will confess that I would not have considered exiting the market in 2007 because valuations were reasonable and it was hard to see that the sub-prime issue would spread throughout the economy so quickly. However during the tail end of the dot-com / telecom bubble I do think there were stark choices to be faced, and claiming that the markets were efficient and rationally priced was a convenient excuse. I am not sure what your asset allocation recommendations were then, but if I were a financial advisor I would have taken the career risk of advising much lower equity allocations.

[Rick Ferri]

Rick, I am not sure what your asset allocation recommendations were then, but if I were a financial advisor I would have taken the career risk of advising much lower equity allocations.

Easily said with 20/20 hindsight. But that is not my game anyway.

I do advise people to lower their risk in a portfolio based in each person's financial goal and how close they are to it. If a person has the goal of accumulating $2 million for retirement at age 65, and they are at $1.8 million by the time they are 62, then that warrants a low risk portfolio because they can coast into $2 mm with low risk. On the other hand, when a 65 year old needs $2 million and they have $4 million, the risk can be higher because the extra $2 million is being invested for the next generation.

Rick Ferri

[saurabhec]

Rick, I am not sure what your asset allocation recommendations were then, but if I were a financial advisor I would have taken the career risk of advising much lower equity allocations.

Easily said with 20/20 hindsight. But that is not my game anyway.

Fair enough. I do think you should not be too judgemental about those who might be worried about bubble risk as long as there is some basis for it, and it is a once in 10-20 years kind of a call, and not something done by some nervious nellie every couple of years. I think EMH is a very useful theory but once in a while it can be used as a crutch to enable the path of least resistance.

[superlight]

What you missing is the performance of active managers verses the 'irrational' market. If the market is not priced rationally, and it is easy to tell when and where is it being irrational, then why are there not more active managers outperforming the market? Are the active managers just to dumb to figure this out.

I think this is the connection "old line" EMH people need to break.

There is not in fact any reason that an irrational market should be predictable or exploitable.