The Myth of the Rational Market, by Juston Fox, is an important book. It does a fine job of explaining the analytical mistakes made by efficient market proponents that caused the economic crisis. However, it fails to describe how we need to change the investing advice promoted to middle-class investors to escape the crisis (this article was posted in December 2011) and to avoid future ones.
Fox begs off, saying “This book offers no grand new theory of how markets truly behave.” I wish it did. The book does a great job of telling the story of how we came to find ourselves in the giant mess we find ourselves in today. But we need help in figuring out what to do to get out of the mess. I wish that Fox had devoted his mental energies to helping us discover where we need to go from here (I of course believe that the answer is to work together to bury Buy-and-Hold 30 feet in the ground, where it can do no further harm to humans and other living things, and to replace it with Valuation-Informed Indexing).
#1 Myth of the Rational Market — The Idea that Markets Are Properly Priced Is the Product of Recent Academic Research
The reality is that the dangerous idea that the stock market is efficient has been around for a long, long time. Fox points out in his Introduction that George Rutledge Gibson argued in 1889 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.”
Stock investors can bid stock prices up to whatever they want them to be. But how can they have confidence in prices set through an arbitrary process that takes little account of the economic realities? They assure themselves that the market is “efficient,” that the market as a whole is too rational to let emotion cause it to set stock prices improperly. We have been both indulging and rationalizing our Get Rich Quick impulse since the day on which the first stock market opened for business.
#2 Myth of the Rational Market — Investors Act in Their Self-Interest to Maximize Returns and Diminish Risk
The efficient market concept is rooted in the idea that investors act in their self-interest to maximize returns and diminish risk. If we cannot count on that much, none of the “science” supporting today’s conventional investing wisdom holds up. That’s the basic building block on which all Buy-and-Hold strategies are built.
Yet Fox puts forward in his book numerous examples of how reason failed the “experts” with the greatest faith in its power. One painful example of the phenomenon is put forward on Page 25. Irving Fisher, one of the experts advocating Buy-and-Hold strategies in the late 1920s, “held on to his Remington Rand stock as it dropped from $58 to $1.”
The idea of holding stocks that represent a solid long-term value proposition makes all the sense in the world. That’s Warren Buffett’s insight: If you have made a good choice, you need to stick with that choice long enough to obtain the rewards that follow from it and that can take some time given the general irrationality of the market. Buy-and-Holders pervert Buffett’s insight by claiming that holding is always a good idea, even when the initial investing choice was a poor one. Nothing could be further from the truth.
This is why Buy-and-Hold often proves to be the worst of all possible strategies. Short-term timing doesn’t work. But short-term timers are at least able to sell when their bets go bad. Buy-and-Holders stick to bad choices until they have suffered enough financial devastation to force them to abandon their “hold forever” vows.
Sticking with an investment choice is a good thing only when the choice itself is a solid one. When it is not (and Buy-and-Holders have no way of knowing whether their choices are good ones or not since they do not evaluate the value proposition being offered by stocks at a particular time prior to buying), sticking produces the worst of all possible results — large losses locked in when stock prices are at a bottom and about to move up again soon.
#3 Myth of the Rational Market — There Are Scientific Studies Supporting Buy-and-Hold Strategies
Buy-and-Holders claims that their strategies are scientific. But it’s a funny kind of science that ignores investor behavior when analyzing what works in the stock market.
Fox observes on Page 28 that: “Like physicists ignoring friction in building their models of the world, economists became more and more comfortable with ignoring widely recognized realities of human behavior in order to build better models of it.”
He adds on Page 29 that: “Equations were memorized and passed on. The accompanying words, and often the real-world data against which the formulas were tested, were forgotten.” We had reason to doubt the legitimacy of Buy-and-Hold for years before it tanked our economy in September 2008.
#4 Myth of the Rational Market — We Have Proven That Market Prices Move Randomly
Millions of middle-class investors have to their misfortune been led to believe that this is so. The reality is quite to the contrary.
Fox describes Paul Samuelson’s work on Page 72. Samuelson wrote: “Randomness can only be defined negatively; namely, as the absence of any systematic pattern. A particular test can detect only a particular pattern or class of patterns, and complete randomness can therefore only be disproved, not proved.”
Randomness has never been proved. There are studies indicating that short-term timing does not work, or that, if it does work, it is hard to pull off. There has never been a study showing that long-term timing does not work. In fact, numerous studies show that it always works. If one form of market timing always works, the claim that market returns are random is false.
#5 Myth of the Rational Market — The Connection Between Risk and Reward Is Clear
Buy-and-Hold advocates say that investors should not be fearful of the risks associated with holding overpriced stocks because it is only by taking on considerable risk that investors can hope to achieve acceptable returns. The reality is that today’s understanding of the connection between risk and return is primitive.
As the book notes on Page 184: “While it was apparent that risk and return were related, it was equally apparent that some risks were rewarded more generously than others…. Profit came when you proceeded in the face of uncertainty.”
If that’s so (I do not believe it is), then Buy-and-Hold is dangerous. If returns are uncertain, Buy-and-Holders are taking a big chance. They cannot know that they will even in the long term obtain a decent return on their money. If they could, the uncertainty of their investment choice would be eliminated and they would no longer be entitled to a good return.
My personal belief is that investors are not compensated for taking on risk but for giving up the profit-generating capacity of their capital for a time. If that’s so, investors taking on little risk can in the right circumstances earn higher returns than investors taking on great risk. In that case, investors taking on the high risk associated with buying stocks selling at high prices are unlikely to be compensated for doing so.
#6 Myth of the Rational Market — The Efficient Market Concept Has Been Clearly Enough Defined to Help Investors Know How Best to Invest Their Retirement Money
Fox quotes University of Chicago Economics Professor Eugene Fama as explaining that: “In an efficient market, the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value.” He then observes that “just how far security prices wandered from those intrinsic values remained an important topic for further research.”
In January 2000, stocks were priced at three times their fair value. If it is possible for stock prices to wander that far from intrinsic value, it can fairly be said that Buy-and-Hold is the purest and most dangerous Get Rich Quick scheme ever concocted by the human mind. Yet Fox’s comment suggests that the Efficient Market Concept was never clearly enough defined to rule out the possibility. Oops!
#7 Myth of the Rational Market — The Case for the Efficient Market and for Buy-and-Hold Is So Strong That Pretty Much All Experts Accept It
The reality is that Efficient Market proponents have long closed their minds to challenges to their ideas. “A new paradigm had been accepted, and those who didn’t want to work within it were no longer welcome,” Fox writes on Page 106. Science? Not in my assessment. Legitimate science yields a greater level of confidence in one’s work.
#8 Myth of the Rational Market — Investors Pursue Their Self Interest
The reality is that “we are often of two minds, one that impatiently demands satisfaction now and another that rationally weighs present and future rewards.” (Page 186)
That explains why stocks have always provided poor returns for the 20 years immediately following bull market tops. As we shift from pushing stock prices up to unsustainable high prices to pulling them back down to proper price levels, market returns are low not because the underlying companies are not generating profits but because we are paying back the debt we incurred to ourselves during the bull market years in which we impatiently demanded the immediate satisfaction delivered by insanely high stock prices.
Does Buy-and-Hold make sense in a world in which this is the reality? Can any middle-class investor hope to be able to retire at a reasonable age by investing heavily in an asset class priced to provide 20 years of poor returns? Are we pursuing our self interest when we follow Buy-and-Hold strategies or when we permit bull markets to develop or when we encourage others to follow Buy-and-Hold strategies and thereby to suffer losses so great as to bring on an economic crisis?
The future of investing analysis is coming to a better understanding of why investors often fail to pursue their self interest and developing tools to help them avoid the Get Rich Quick urges that throughout history have so often caused them to pursue self-destructive strategies.
#9 Myth of the Rational Market — The Research Said to Support Buy-and-Hold Should Give Confidence to Indexers
Leaving aside the question of whether the market really is efficient, there are no grounds to believe that Buy-and-Hold strategies can work for indexers. Fox states on Page 194 that: “Fama had proposed that the way to test the efficient market hypothesis was to see if stock price movements obeyed the dictates of the capital asset pricing model, but this was only a relative test. It might reveal whether stock price movements made sense in relation to each other and the overall market, but it was no help in showing whether the overall market was correctly priced or not.”
Now they tell us!
#10 Myth of the Rational Market — There Is No Good Alternative to Buy-and-Hold
The case for Buy-and-Hold is so weak that advocates have in recent years been driven to offering the most defensive case imaginable. We need to stick with Buy-and-Hold, the argument goes, not because the case for it is persuasive but because we do not have an acceptable alternative.
The Myth of the Rational Market makes reference to this argument on Page 298. It quotes Fama as saying: “I don’t know what asset pricing would look like in a world that really took behavioral finance seriously. If you really think prices are incorrect, what are you going to tell me about the cost of capital?”
The sensible response is provided a but farther down on the same page. Dick Thaler, a behavioral finance advocate, acknowledges that “it’s going to be a big mess because human nature is a mess…. It’s a choice between being precisely wrong or vaguely right.”
We are today living through the effects of having for 30 years promoted a model for understanding stocks that the academic research reveals to be precisely wrong. I have hopes that the human misery is reaching a point at which we will as a society come to develop a hunger for one that is instead vaguely right.