Thursday, June 11, 2009

Justin Fox Book Like The Market

The Myth of the Rational Markets, is highly imperfect. It exaggerates, omits, and occasionally inconsistent. Yet, looking at the Barnes and Noble Business & Investments section, it is the best book there I haven't fully read, and much better than any book about the current financial mess.

Fox took exception to my earlier post, in that I criticized his criticism of 'rational' or 'efficient' markets, and Fox noted he presents both sides. I was responding to the reviews, his title, and book cover, and it wasn't clear I hadn't read his book, which is actually a very even handed portrayal of efficient markets, and portfolio theory. Yet I find it amusing he is shocked, shocked, to think one would infer 'Myth of the Rational Market: History of Risk, Reward, and Delusion on Wall Street' suggests markets are generally not rational, or efficient. The cover jacket that states "the efficient market hypothesis has evolved into a powerful myth", and that now "scholars who no longer teach ... the markets are always right." Where would one infer he is criticizing a caricature?

I remember Johah Goldberg complaining that Liberals tended to dismiss his book 'Liberal Fascism' as labeling liberals as fascists, even though within the he states several times he is not saying that in the text. OK. Then why the title? Could it be because 90% of your potential audience has this predilection, and so does he? While we expect book jackets to be over-the-top (lots of brilliant, revolutionary books supposedly), you should expect people to draw inferences from your title. [Truth be told, I didn't title my upcoming book, but I probably had less pull, and it's not misleading].

I've only read the first and last chapter. Unlike Tyler Cowen, I only read about a book a fortnight. I skimmed the middle and will finish over the next week. But it is classically good nonfiction science in that he draws you in with personal vignettes that make you feel like you were there, and outlines many important people in the history of financial theory and issues in modern finance. As a finance geek that's near my interest in the way that wanna-be celebrities read People magazine. He doesn't have any equations, which is like a physics book without equations: while you can feel like your really understand the state of physics reading A Brief History of Time, you can't really understand the key issues, though it is a good read and it may pique your interest to major in finance.

Anyone with a strong opinion on the concept of rationality in finance will find his treatment a bit too easy on the other side. Yet, while I have an opinion I know it is a minority one, and technical, surely not one for a broad audience. The bottom line is that there are several important issues in finance that are contentious, and the reader will leave aware of this, which for most readers leaves them much the richer. Is the Dick Thaler view more productive than Eugene Fama's? Well, they both suggest index funds, so what's the essence of their difference? It's not obvious, other than semantics. Is the issue merely, whether one wants to call the same thing 'inefficient' or 'efficient', because of the broader implications for the invisible hand and thus regulation? Thaler runs diversified funds with tilts towards size and value, Fama is affiliated with Dimensional Fund Advisors, which has size and value tilts. One thinks 'size' is a risk factor, the other thinks it's an inefficiency. They both think most investors prefer to buy this slant, and are mindful of momentum. Thaler notes 'it's better to be vaguely right than precisely wrong', yet one could say that's why the market is better than fundamental analysis as opposed to vice versa. Figuring out the real essence of their difference is outside this book.

For example, I think Thaler is a real lightweight, in that his fame DeBondt and Thaler pieces were so contaminated by the low-prices, and have not been updated the way that momentum, the opposite of his findings, has. But that gets to my point. Getting into detail on what and why one disagrees gets technical very quickly, anathema to a book aimed at a broader audience.

I think Fox tends to side more against Fama than for him, but found the book's strong point was not creating a case for his client ('irrational/inefficient' markets) the way, say, Burton Malkiel advocated for his client ('rational/efficient' markets). The most successful 'irrational markets' books are either politically motivated, which have a stable but limited appeal usually advocating some liberal agenda, or really rich guys who can credibly present their wacky alternative to efficient markets based on how frickin' rich they are (Soros, Schiff). I sense Fox wants this book to be read in 10 years, and so he merely tries to let both sides speak their peace, in the process drawing on his strengths as a writer to make you feel like you are right there as the great ideas are being created.

As modern finance is a muddle, I should not blame his book for being a muddle itself. It gives you information, insight, not wisdom. Peter Bernstein's Capital Ideas was a ridiculously slavish hagiography of Modern Portfolio Theory, which is much less successful than the Efficient Markets Hypothesis. It gives a misleading view of the state of finance. If we are to present these ideas, either advocate one side well, like Malkiel's Random Walk, or shows there's a vibrant other side and present them both, like letting Republicans describe Democrats and vice versa. There are many worse ways to present the current debate, and this shelf needed something new.


Anonymous said...

"Well, they both suggest index funds, so what's the essence of their difference? It's not obvious, other than semantics. Is the issue merely, whether one wants to call the same thing 'inefficient' or 'efficient', because of the broader implications for the invisible hand?"

This is not just about semantics or broader implication for the invisible hand, it goes to the heart of how we define risk. Finance is about risk and return.
Knowing at what cost you are receiving an excess return is more than a simple academic exercise.

Eric Falkenstein said...

I agree, but that would have pushed that point more broadly which the book did not do (I'm not done with it, however). I address that specific issue in my book. Namely, if risk and return are hand in hand, why the focus on small cap and value? While DFA presents both, it started as a Small Cap oriented fund. As much as I agree with 'efficient markets' more broadly, I think Fama is inconsistent on this in practice.

Justin Fox said...

You're totally right about the title. I think David Brooks once said that the key to a successful nonfiction book title is that it make a false/dubious/exaggerated claim not really supported by the more nuanced actual text of the book ('The End of History' is the classic example of this). I don't think 'The Myth of the Rational Market' is quite that egregious, but it does position me farther out on one side of the spectrum than I am.

Anyway, all I wanted was to get you to start reading the book, and I'm so glad you did. Thanks!

Nat said...

Your posts have been fantastic the past few weeks. When is your book coming out? Does it have a title yet?

Anonymous said...

seeking alpha, clusterstock...maybe some day one can only hope.
when can we expect the newsletter? those who can't...

Eric Falkenstein said...

thanks guys. Book will be out soon and I have lots of info on it.