The Myth of the Rational Market A History of Risk, Reward, and Delusion on Wall Street Justin Fox To Allison Contents Introduction: It had been Working So Exceptionally Well Early Days Irving Fisher Loses his Briefcase, and Then his Fortune The first serious try to impose reason and science upon the market comes in the early decades of the twentieth century It doesn’t work out so well A Random Walk from Fred Macaulay to Holbrook Working Statistics and mathematics begin to find their way into the economic mainstream in the 1930s, setting the stage for big changes to come The Rise of the Rational Market Harry Markowitz Brings Statistical Man to the Stock Market The modern quantitative approach to investing is assembled out of equal parts poker strategy and World War II gunnery experience A Random Walk from Paul Samuelson to Paul Samuelson The proposition that stock movements are mostly unpredictable goes from intellectual curiosity to centerpiece of an academic movement Modigliani and Miller Arrive at a Simplifying Assumption Finance, the business school version of economics, is transformed from a field of empirical research and rules of thumb to one ruled by theory Gene Fama Makes the Best Proposition in Economics At the University of Chicago’s Business School in the 1960s, the argument that the market is hard to outsmart grows into a conviction that it is perfect The Conquest of Wall Street Jack Bogle Takes on the Performance Cult (and Wins) The lesson that maybe it’s not even worth trying to beat the market makes its circuitous way into the investment business Fischer Black Chooses to Focus on the Probable Finance scholars figure out some ways to measure and control risk More important, they figure out how to get paid for doing so Michael Jensen Gets Corporations to Obey the Market The efficient market meets corporate America Hostile takeovers and lots of talk about shareholder value ensue The Challenge 10 Dick Thaler Gives Economic Man a Personality Human nature begins to find its way back into economics in the 1970s, and economists begin to study how markets sometimes fail 11 Bob Shiller Points Out the Most Remarkable Error Some troublemaking young economists demonstrate that convincing evidence for financial market rationality is sadly lacking 12 Beating the Market With Warren Buffett and Ed Thorp Just because professional investors as a group can’t reliably outperform the market doesn’t mean that some professional investors can’t 13 Alan Greenspan Stops a Random Plunge Down Wall Street The crash of 1987 exposes big flaws in the rational finance view of risk But a rescue by the Federal Reserve averts a full reexamination The Fall 14 Andrei Shleifer Moves Beyond Rabbi Economics The efficient market’s critics triumph by showing why irrational market forces can sometimes be just as pervasive as the rational ones 15 Mike Jensen Changes his Mind About the Corporation The argument that financial markets should always set the priorities—for corporations and for society—loses its most important champion 16 Gene Fama and Dick Thaler Knock Each Other Out Where has the debate over market rationality ended up? In something more than a draw and less than a resounding victory Epilogue: The Anatomy of a Financial Crisis Cast of Characters Acknowledgments A Note on Sources Notes Searchable Terms About the Author Credits Copyright About the Publisher INTRODUCTION IT HAD BEEN WORKING SO EXCEPTIONALLY WELL ON THE FOURTH THURSDAY OF October in 2008, eighty-two-year-old Alan Greenspan paid a visit to Capitol Hill to admit that he had misunderstood how the world works Sitting at the witnesses’ table in the hearing room on the first floor of the Rayburn House Office Building, the former Federal Reserve chairman started by reading a statement that tried to explain what had gone so wrong with financial markets over the past year After asking Greenspan a few questions, the chairman of the House Committee on Government Oversight and Reform, California Democrat Henry Waxman, summed up “In other words,” he said, “you found that your view of the world, your ideology, was not right It was not working.” “Precisely,” replied Greenspan “That’s precisely the reason I was shocked, because I had been going for forty years or more with very considerable evidence that it was working exceptionally well.”1 During those forty years—especially the nineteen during which Greenspan was the world’s top central banker—financial markets grew to play an ever-larger and less-fettered role The stock market boomed for most of Greenspan’s years at the Fed Bond markets boomed too, and expanded into new territory as Wall Street whizzes took mortgage loans and auto loans and credit card debt off the balance sheets of banks and repackaged them into asset-backed securities sold to investors around the world The most dizzying growth came in over-the-counter derivatives, custom-made financial instruments (options, futures, swaps) that tracked the movements of other financial instruments With them, traders could insure against or bet on moves in currencies or interest rates or stocks In recent years it had even become possible to use derivatives to insure against loans gone bad From 1987 to 2007, the face value of over-the-counter derivatives rose from $866 billion to $454 trillion.2 As Fed chairman, Greenspan had celebrated this financialization of the global economy “These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it,”3 he said in 1999, referring to derivatives in particular Greenspan had once expressed the worry, in 1996, that stock markets might be losing themselves in a frenzy of “irrational exuberance.” When they kept rising after that, he took the lesson that the market knew more than he did This was Greenspan’s ideology—and it had been widely shared in Washington and on Wall Street Financial markets knew best They moved capital from those who had it to those who needed it They spread risk They gathered and dispersed information They regulated global economic affairs with a swiftness and decisiveness that governments couldn’t match AND THEN, SUDDENLY, THEY DIDN’T “The whole intellectual edifice collapsed in the summer of last year,” Greenspan admitted at the October 2008 hearing.4 That was when the private market for U.S mortgage securities collapsed, beginning a fitful unraveling of asset market after asset market around the world Distrust spread Many previously thriving credit markets shut down entirely Bank runs— long thought to endanger only actual banks—threatened any financial institution that ran on borrowed money After Greenspan’s successor at the Fed, Ben Bernanke, and Treasury Secretary Hank Paulson decided in September 2008 not to step in to avert such a run on Lehman Brothers, global finance virtually ceased functioning It took a partial government takeover of the financial system—not just in the United States but in Europe—to bring back even a modicum of calm Greenspan struggled to explain what had gone wrong because the intellectual edifice around which he had built his thinking simply didn’t allow room for the events of the preceding fourteen months This was the edifice of rational market theory The best-known element of rational market theory is the efficient market hypothesis, formulated at the University of Chicago in the 1960s with reference to the U.S stock market The belief in the so-called rational market that took hold in the years that followed, though, was about more than just stocks It held that as more stocks, bonds, options, futures, and other financial instruments were created and traded, they would inevitably bring more rationality to economic activity Financial markets possessed a wisdom that individuals, companies, and governments did not The notion that financial markets know a lot has been around as long as financial markets themselves In 1889, stock market chronicler George Rutledge Gibson asserted 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.”5 Hints of this same attitude could be found in the work of early economists such as Adam Smith—and even the religious thinkers of the Middle Ages While some medieval ecclesiastical scholars argued that lawgivers should set a “just price” for every good to guarantee that producers earned a living wage and consumers weren’t gouged, others, St Thomas Aquinas among them, held that the just price was set by the market.6 All these early claims for the correctness and justness of market prices came with caveats— doses of realism, you could call them George Gibson wrote that stock exchanges were prone to manias and panics and called for the regulation of “bucket shops” that urged customers to speculative excess.7 Adam Smith thought corporations with widely dispersed ownership—the shares of which are what make stock markets go—were abominations Thomas Aquinas made no claim that the market price was always right, just that it was hard to come up with a fairer alternative The twentieth-century version of rational market theory was different—both more careful and more extreme It started with the observation that the movements of stock prices were random, and could not be predicted on the basis of past movements This observation was followed by the claim that it was impossible to predict stock prices on the basis of any publicly available information (such as earnings, balance sheet data, and articles in the newspaper) From those starting points—both of which were, it turned out later, not entirely correct—flowed the conviction that stock prices were in some fundamental sense right Most of the scholars who backed this hypothesis early on didn’t mean for it to be taken as a literal description of reality It was a scientific construct, a model for understanding, for testing and engineering new tools All scientific models are oversimplifications The important test is whether they’re useful This particular oversimplification was undeniably useful, so useful that it took on a life of its own As it traveled from college campuses in Cambridge, Massachusetts, and Chicago in the 1960s to Wall Street, Washington, and the boardrooms of the nation’s corporations, the rational market hypothesis strengthened and lost nuance It was a powerful idea, helping to inspire the first index funds, the investment approach called modern portfolio theory, the risk-adjusted performance measures that shape the money management business, the corporate creed of shareholder value, the rise of derivatives, and the hands-off approach to financial regulation that prevailed in the United States from the 1970s on In some aspects the story of the rational market hypothesis parallels and is intertwined with the widely chronicled rebirth of pro-free-market ideology after World War II But rational market finance was not at heart a political movement It was a scientific one, an imposing of the midcentury fervor for rational, mathematical, statistical decision making upon financial markets This endeavor was far from an unmitigated disaster It represented, in many ways, the forward march of progress But much was lost, most importantly the understanding—common among successful investors but absent from several decades of finance scholarship—that the market is a devilish thing It is far too devilish to be captured by a single simple theory of behavior, and certainly not by a theory that allowed for nothing but calm rationality as far as the eye could see As far back as the 1970s, dissident economists and finance scholars began to question this rational market theory, to expose its theoretical inconsistencies and lack of empirical backing By the end of the century they had knocked away most of its underpinnings Yet there was no convincing replacement, so the rational market continued to inform public debate, government decision making, and private investment policy well into the first decade of the twenty-first century—right up to the market collapse of 2008 This book offers no grand new theory of how markets truly behave It is instead a history of the rise and fall of the old theory—the rational market theory It is a history of ideas, not a biography, or even a collection of biographies But it is full of characters—most of them economists and finance professors—who were actors in many of the great dramas of the twentieth century, from 1920s boom to 1930s Depression to war and then peace and prosperity, then 1960s boom and 1970s bust and so on These characters weren’t the lead actors, for the most part But they were crucial to the plot (A reference list of key players can be found on backmatter.) “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,” wrote John Maynard Keynes, who plays a supporting role in the story to follow “Indeed, the world is ruled by little else Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The defunct economist with whom this tale begins is Keynes’s contemporary Irving Fisher EARLY DAYS Money, 291 The Money Game (Goodman), 120, 193 Monitor Group, 283 Monks, Robert A G., 272, 273 Moody’s, 15, 116 Moore, Arnold, 69, 99–100 Morgenstern, Oskar, 49–52, 54, 70, 77, 192–93, 326 Morningstar, 143 mortgage loans, xi–xii, xii mortgage-backed securities, 313–15 Mossin, Jan, 88 Munger, Charlie, 216, 221, 278 Murphy, Kevin J., 275 Muth, John, 179 mutual funds and Buffett, 216 and Edgar Smith, 22 and 401(k)s, 291 and hedge funds, 215 origin of, 113–15 and pensions, 136–38, 273 and performance measures, 120–28, 213, 306–7 and unmanaged funds, 111–13, 125 Myers, Stewart, 355n 38 Nader, Ralph, 159, 165 Nasdaq, 17, 242, 261 The Nation, 156 National Bureau of Economic Research (NBER), 26, 31–32, 76, 93, 167, 182–83, 251, 349–50n 2, 352n National Business Conference, 24 National Quotation Bureau, 16–17 Nature, 40–41 The Nature of Capital and Income (Fisher), 4–5,12–13, 31 Naval Research Laboratory, 69–70 neoclassical economics, 10, 29–33, 61, 235, 311, 365n Neumann, John von, 49–52, 54–55, 70, 77, 176 New Deal, 90, 220–21 New School for Social Research, 51 New York Herald-Tribune, 23, 156 New York Society of Security Analysts, 118, 119 New York Stock Exchange (NYSE), 98, 116, 145, 189, 205–6, 220, 230–33, 242–44 New York Times, 24, 38, 98, 130, 170, 273, 275 New York Times Magazine, 159 New Yorker, 68, 118 Newsweek, 73–74 Newton, Isaac, 17, 24 Niederhoffer, Victor, 203 Niehans, Jürg, 60 Niskanen, William, 295 Nobel Prize in Economics, 52, 107, 139, 147, 176, 183, 193, 235, 289 normal distributions, 6, 27, 132, 133, 139 Northern Pipeline Co., 155 Obama, Barack, 295, 326 O’Brien, John, 151–52, 228 Odean, Terrance, 292 oil crises, 162–63 “On Credit Cycles and the Origin of Commercial Panics” (Mills), 310–11 One Market, Under God (Frank), 269 operations research (OR), 47–48, 58, 67–68 opportunity cost, 13, 84 options and arbitrage, 220, 283 and Bachelier, 66 and executive compensation, 276–79, 280 and hedge funds, 218–19 and leverage, 350–51n 15 and pricing formulas, 227–28, 235 and quantitative finance, 143–50 and volatility, 233–34 and warrants, 62–63, 218 Orange County, California, 362n 17 Osborne, M F M., 67–69, 132, 134–35, 203, 204, 238, 326 over-the-counter derivatives, 236, 240 Oxford University, 32 Palm, 262 paradigm shifts, 106–7 The Paradox of Asset Pricing (Bossaerts), 297 Pareto’s Law, 349–50n Paris Bourse (exchange), 6, 144 Paulson, Hank, xiii Peltz, Nelson, 168 pension funds and derivatives, 151–52 and 401(k)s, 290–91, 295 and investment advisors, 142–43 and management actions, 253 and mutual funds, 127–28, 136–38, 140, 142 and performance measures, 249 and portfolio insurance, 228, 229 and portfolio theory, 169 and shareholder value, 272–74 “Persuasive Evidence of Market Inefficiency,” 224 Pickens, T Boone, 271 Plott, Charles, 189–90 Poincaré, Henri, 6, 7–8, 11, 12, 27, 66, 148–49, 307 poker, 49–50 See also game theory politics, 20, 269, 319 Ponzi finance, 312–15 portfolio insurance, 150–51, 227–28, 229–31, 236–39 Portfolio Selection, 55 portfolio theory, xiv, 48–52, 55–59, 65, 85, 104, 137, 169 power laws, 133, 134 Prais, Sig, 64, 65 Predictability of Stock Prices (Granger), 192–93 Prediction Company, 304 The Predictors (Bass), 304 price-to-book ratio, 208–9, 224 price-to-earnings (P/E) ratio, 204, 206, 257, 260 Princeton University, 50 Princeton-Newport Partners, 218–19, 220, 242 Principles of Corporate Finance (Brealey and Myers), 355n 38 Principles of Economics (Marshall), 30, 33, 189, 301 probability, 7–8, 13–15, 50–51, 62, 135, 177 “Proof that Properly Anticipated Prices Fluctuate Randomly” (Samuelson), 73, 144 prospect theory, 184, 186, 191, 291, 298 “Prudent Man” rule, 137 psychology, 176–78, 183–88, 201, 232–33, 266, 293–95 See also behavioral finance Purchasing Agents Association, 24 Putnam Investors, 112 Quantitative Finance, 305 Quarterly Journal of Economics, 63 Rand, Ayn, 91, 258 RAND Corporation, 55, 59, 86 A Random Walk Down Wall Street (Malkiel), 129–30 random walk hypothesis and the business cycle, 26–28 and computing, 99–101 and Cowles, 35–39 and Fama, 96–97 and ideological debate, 29–35 and Malkiel, 129–30 and market uncertainty, 13 modeling, 28–29 and options, 146 and the public consciousness, 99 and Samuelson, 60–66, 67–70, 70–74 and social value of markets, 39–44 Rappaport, Alfred, 164, 271, 280 rational market hypothesis, xiii–xv, 35, 82–83, 107, 179–80, 197, 251, 287–88 See also efficient market hypothesis Read, Dillon, 114 Reader’s Digest, 91 Reagan, Ronald, 151, 168, 274–75 real estate markets, 256–57, 312–15 Reder, Melvin, 89–90 Reed, John, 187, 302 Regan, Donald, 168 Regan, Jay, 218 Remington Rand, 21, 22, 25 Renshaw, Edward F., 111 Ricardo, David, 193 risk and asset-backed securities, xii defining, 228–29 and derivatives, 150–51 and diversification, 54, 86–87 and executive compensation, 280 and market efficiency, 102 modeling, 58, 86–88, 208, 237–38, 243, 314, 316 and normal distribution of prices, 132 and options, 149 and the parable of talents, 84 and portfolio theory, 137 and price disparity, 184–85 and risk premiums, 141–43, 263–64 and risk-adjusted performance, xiv, 228 and variance, 138 Risk, Uncertainty, and Profit (Knight), 84–85 RiskMetrics, 238 The Road to Serfdom (Hayek), 90, 91 Roberts, Harry, 69, 70, 96, 100–101, 326 Robertson, Julian, 260 Rockefeller, John D., 31 Rockefeller Foundation, 155, 352n Roe, Mark, 365n 18 Roll, Richard, 100, 103, 182, 202, 224–25, 259, 297–98, 326, 359–60n 34, 361n Roosevelt, Franklin Delano, 33, 156 Rosenberg, Barr, 127, 138–39, 139–40, 151, 224, 326–327 Rosenfeld, Eric, 225 Ross, Steve, 149–50, 224–25, 235, 237, 327, 359–60n 34 Roy, A D., 48, 65 Royal Economic Society, 22 Royal Statistical Society, 41, 64 Rubinstein, Mark, 59, 151, 228, 233, 292, 327 Russell Investments, 142–43 Russell P Sage Foundation, 187, 302 Russia, 241, 363n Salomon Brothers, 225, 240, 241 Samuelson, Paul, 327 and Beat the Market, 218 and Buffett, 223 and commodities markets, 132, 223–24 and Fisher, 10 and imperfect competition, 181 and index funds, 131 and Keynesian economics, 35 and Lucas, 180–81 and Merton, 147 and mutual fund management, 123–24 and options, 144 and the random walk hypothesis, 60–66, 67–70, 72, 73, 129–30, 196 and revealed preference, 184 and Roll, 103 and Senate testimony, 123–24 and Summers, 198, 358n 19 Santa Fe Institute, 301–4 Savage, Leonard “Jimmie,” 52, 56, 65, 75, 77, 176–77, 327 Scholes, Myron, 327 and capital asset pricing model (CAPM), 346–47n 30 and the Chicago School of Economics, 100 and derivatives, 151 and “joint hypothesis,” 105 and Long-Term Capital Management, 240 and Nobel Prize, 235–36 and options, 145, 147, 149, 277–78 and Quantitative Finance, 305 and Shleifer, 247–48 and trading strategies, 225–26 and Wells Fargo, 127 Schumpeter, Joseph, 36, 53, 341n 14 Schwartz, Anna, 93 Schwert, G William, 359n 25 Science, 178, 185 Sears, 273 Securities and Exchange Acts, 156 Securities and Exchange Commission, 33, 98, 112, 125–26, 130, 156, 166, 168, 279–80 securities market, 15–16, 66, 314–16 Security Analysis (Graham and Dodd), 53, 117, 118, 131, 211 Senate Banking Committee, 123–24 Shakespeare, William, 57 shareholder value, 83, 164, 270, 271–74 Sharpe, William, 327 and asset pricing, 87–88, 104, 141, 149 and Buffett, 223 and the coin-flip analogy, 212 and derivatives, 152 and endogenous change, 305–6 and 401(k)s, 294–95 and investment advisors, 143 and market crashes, 231 and the Merrill Foundation, 126 and mutual funds, 125 and Nobel Prize, 235 and pension funds, 272 and performance measures, 123, 132 and portfolio selection, 86 and Stanford Business School, 136 and variance, 139 and Wells Fargo, 127 Shefrin, Hersh, 186–87, 191–92, 200, 201, 293, 359n 25 Shiller, Robert, 320–21, 328 and bull markets, 256 and democratization of the market, 237 and the efficient market hypothesis, 203 and Fama, 207 on “irrational exuberance,” 263, 297 and Jensen, 213 and market bubbles, 259, 269–70, 316–17 and market crashes, 232 and the rational market hypothesis, 196–98 and stock forecasts, 258 Shleifer, Andrei, 247–48, 250–52, 252–55, 269, 299–300, 328, 363n short sales, 214–15 See also options Siegel, Jeremy, 256, 262–63 Silicon Valley, 278 Simon, Herbert, 77, 80, 178–79, 183, 187, 328, 341n Sinquefield, Rex, 105, 128, 140–42, 225, 350n 12 Skinner, B F., 355n Sloan School of Industrial Management, 70–71, 71–72 Slutsky, Eugene, 41–42, 51 small-cap stocks, 205–6, 208–9 small-stock effect, 225, 296 Smith, Adam and agricultural futures, 39–40 and corporations, xiv, 153–54 and equilibrium theory, 78, 193 Smith, Adam and the “invisible hand,” 9, 158–59, 335n 11 and neoclassical economics, 29–30 and rational market hypothesis, xiii Smith, Edgar Lawrence, 21–22, 25, 38, 99, 141, 256 Smith, Vernon, 188–89, 289 social Darwinism, 9, 93 social responsibility, 159–61 socialism, 91 Society for the Advancement of Behavioral Economics, 187 Soros, George, 266 South Africa, 12 South Sea Bubble, 16, 153 S&P 500, 19–20, 38, 128, 163, 196, 219–20, 227, 230, 249, 260 Sparkman, John, 124 spectral analysis, 70 Standard & Poor’s, 16–17 See also S&P 500 standard deviation, Standard Oil, 15 Standard Statistics Co., 15, 16–17, 19, 38, 116 Stanford Business School, 135 Stanford Center for Advanced Study in Behavioral Sciences, 106–7 State Street Global, 112, 143 Statistical Research Group, 47–48, 52 Statman, Meir, 186–87, 200, 359n 25 Stern, Joel, 163–64, 222, 270 Stigler, George, 90, 92, 95, 159, 182 Stiglitz, Joseph, 181, 196, 202, 207, 288, 328 Stocks for the Long Run (Siegel), 256 Strong, Benjamin, 20, 24 The Structure of Scientific Revolutions (Kuhn), 107, 203 Stulz, René, 251–52 subprime lending, 313–15 subsidies, 194 Summers, Lawrence, 328 and Black, 200 and the efficient market hypothesis, 203 and Fama, 207 and market crashes, 232 and the National Bureau of Economic Research, 183 and overvaluations, 269–70 and political appointments, 252 and Samuelson, 198, 358n 19 and the Santa Fe conference, 302 and Shiller, 198–99 and Shleifer, 248, 250–51, 363n Sumner, William Graham, 9, 10, 12, 31, 93 Sun Life Canada, 27 Sunstein, Cass, 295 superior intrinsic-value analysis, 97 supply-demand graphs, 30 Surowiecki, James, 307 Taleb, Nassim Nicholas, 239 taxes, 244, 274–77, 280 tech bubble, 261–62 Technical Analysis of Stock Trends (Edwards and Magee), 68 technological advance, 120, 258 See also computers telecommunications firms, 266–67 Texaco, 271–72 Thaler, Richard, 328 and behavioral finance, 186–87, 201, 288–89, 292–95, 296–97, 298 and fund management strategies, 253 and market anomalies, 206 and market crashes, 233 and the rational market debate, 191–92, 287–88 and risk modeling, 184–88 satirical depiction of, 287–88 and Shleifer, 252 Théorie de le spéculation (Bachelier), 65 The Theory of Finance (Fama and Miller), 105 Theory of Games and Economic Behavior (Von Neumann), 50–51 The Theory of Interest (Fisher), 36 The Theory of Investment Value (Williams), 53–54, 87 Theory of Monopolistic Competition (Chamberlin), 188–89 Thomas Aquinas, xiii, xiv Thorp, Edward O., 146–47, 214, 216–21, 222–23, 230, 240, 242, 328 3Com, 262 three-factor model, 209–10 tight prior equilibrium, 89–90 Time Warner, 267 Tito, Dennis, 152 Tobin, James, 244, 302 Tobin tax, 244 trade deficits, 230 Travelers, 241 Treasury Inflation-Protected Securities (TIPS), 19 Treynor, Jack, 83–85, 88, 122–23, 125–27, 132, 139, 141, 149, 329 Trilling, Lionel, 91 Tsai, Gerry, 120, 124–25, 166 tuberculosis, 4, 12–13, 16 tulip market, 15–16 Tullock, Gordon, 159 Tversky, Amos, 176–77, 183, 185–86, 191–92, 201, 289, 291, 316, 329 “Uncertainty, Evolution and Economic Theory,” 93 United Kingdom, 40, 48 University of California, Irvine, 216 University of California, Los Angeles (UCLA), 86 University of Chicago (Chicago School of Economics) and academic isolation, 89–90 early growth of, 94–97 and efficient market hypothesis, xiii and experimental economics, 190 and Follies event, 287–89 founding of, 94–97 and Hayek, 92 and hostile takeovers, 167–68 and Knight, 84–85 and market efficiency, 101–5 and Miller, 237 and Mitchell, 31 and portfolio theory, 169 and the rational market hypothesis, 180 and role of businesses, 268 and Samuelson, 60–61 and unmanaged funds, 111 University of Chicago Law School, 157–58 University of Chicago Press, 90–91 University of Rochester, 107, 169, 275 Unruh, Jesse, 272, 273 U.S and Foreign Securities Corp., 114 U.S Congress, 137–38, 276, 280, 313–14 U.S Department of Agriculture, 195 U.S Department of Labor, 138 U.S House of Representatives, 40 U.S Naval Research Laboratory, 67 U.S Senate, 40, 123–24 U.S Steel, 15, 277 U.S Supreme Court, 276 “The Use of Knowledge in Society” (Hayek), 91–92 utility theory, 10, 30, 51–52, 75 value at risk (VaR), 238–39 value investing, 116–18, 206, 215–16, 226, 255, 260 Vanguard, 129, 131 variance, 134–35, 138–39 Veblen, Thorstein, 30–31, 33–34, 76, 157 Viniar, David, 316 Vishny, Robert, 252–55, 300 volatility, 138–39, 144–45, 197, 233–34 Von Neumann-Morgenstern expected utility, 51–52, 54, 75, 80, 176–77, 193 wage controls, 136–37 Waldmann, Robert, 251 Waldrop, Mitchell, 302, 304–5 The Wall Street Journal, 15, 17–18, 26, 112, 163, 219, 224, 231–32, 235, 262–63 Wall $treet Week, 163 Wallis, W Allen, 48, 90, 95, 161 Walras, Léon, 12 Wanner, Eric, 187 warrants, 21, 62–63, 145, 217–21 Waxman, Henry, xi The Wealth of Nations (Smith), 154, 334n 11 Welch, Jack, 270–71 Wellington Management, 112, 115, 128–29 Wells Fargo Bank, 127–28 Wells Fargo Investment Advisors, 143 Weston, Fred, 106 Weymar, Helmut, 223 Wharton School, 102, 106 What the Social Classes Owe to Each Other (Sumner), 9, 93 When Genius Failed (Lowenstein), 239–40 Williams, Harrison, 165 Williams, John Burr, 24, 53–54, 78, 82, 87, 118–19, 196, 214–16, 262, 341n 14 Wilshire 5,000, 152 Wilshire Associates, 142–43, 152 Wilson, Charlie, 156–57 Windsor Fund, 122 Wolfson, Lewis, 165–66 Woodward, Bob, 258 Working, Holbrook, 329 and agricultural futures, 93 and economic Brownian motion, 73 and efficient market hypothesis, 194–95 and Kendall, 64–65 and the Merrill Foundation, 55, 126 and quantitative approach, 47 and random walk theory, 69, 70 and the rational market hypothesis, 303 and social value of markets, 39–44 World War I, 18 World War II, xv, 29, 42, 47–48, 67 WorldCom, 267, 283 Yale Law Review, 156 Yale University, 9, 123 Yule, George Udny, 41–42 Zacks, 281 Zandi, Mark, 314–15 Zipf, George, 133 About the Author JUSTIN FOX is the business and economics columnist for Time magazine and the author of the popular Time.com blog The Curious Capitalist (www.time.com/curiouscapitalist) Previously an editor and writer at Fortune, he appears regularly on CNN, CNBC, and PBS’s Nightly Business Report He lives in New York City with his wife and son Visit www.AuthorTracker.com for exclusive information on your favorite HarperCollins author Credits Jacket design by Victor Mingovits Jacket illustration: The Stock Exchange by Rougeron-Vignerot, courtesy Bibliotheque des Arts Decoratifs, Paris, France/Archives Charmet/The Bridgeman Art Library Copyright THE MYTH OF THE RATIONAL MARKET Copyright © 2009 by Justin Fox All rights reserved under International and Pan-American Copyright Conventions By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this e-book onscreen No part of this text may be reproduced, transmitted, down-loaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any form or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of HarperCollins e-books Adobe Digital Edition May 2009 ISBN 978-0-06-188570-9 10 About the Publisher Australia HarperCollins Publishers 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values.16 And Keynesian economics was only tangentially about financial market irrationality Keynes was a product of Alfred Marshall’s Cambridge, not just as a student but as son of one of Marshall’s