Interview with Justin Fox: The Myth Of The Rational Market
Justin Fox is the economics and business columnist for Time magazine and the author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. He also writes the Curious Capitalist blog, named one of the top 25 economics blogs by the Wall Street Journal. Before joining Time in 2007, Fox spent more than a decade working as a writer and editor at Fortune magazine, where he covered economics, finance, and international business.
Q/A (Copyright Miguel Barbosa & Justin Fox 2009-2010)
In “The Myth of the Rational Market,” you explore the evolution of modern finance- from academics suggesting that markets are unpredictable to suggesting that they are perfectly rational. Is this a correct interpretation? What’s the main message of book?
That’s correct. Now everyone denies making that leap, but they really did. In the 1970’s the discussion was whether prices in markets corresponded with fundamental values – and that is one of the main points of my book. The other theme of the book sheds light on a group of financial models that (until recently) seemed to work really well together: that being mostly the Efficient Market Hypothesis, the Capital Asset Pricing Model, and option pricing models. When you add all of these theories, a real belief of rationality and efficiency surfaces which was very prevalent for many decades. From this came the idea that the workings of financial markets could be understood fully and thus financial tools could be designed for rational market participants.
What group would be responsible for the leap between “markets being unpredictable” and “markets being fully rational/efficient”?
It was definitely the business school at the University of Chicago. Eugene Fama often gets identified with it, but in many ways he is less extreme than many of his colleagues and students. Fama was trying to codify what was meant by the existence of efficient markets. There’s an interesting story which I didn’t mention in the book. It involves Baruch Lev, a very distinguished accounting professor at NYU who got his PhD at the University of Chicago. When he was starting to get his degree in accounting, many finance students would approach him at parties asking “Why bother studying accounting? None of it matters. Markets would see through any accounting standards or shenanigans.” This is a pretty good example of extreme thinking.
As a value investor, I would say most of us focus completely on accounting. Occasionally, we do come across people telling us that we’re wasting our time.
Sure, they say, “Why bother?”
It’s interesting that you mention this story. Were there any other topics or economists that you left out of the book? Also, it seems like your book picks up where Bernstein’s book “Capital Ideas” left off. What was your relationship with Bernstein?
“The Myth of The Rational Market” came out of an article I wrote for Fortune Magazine in 2002. Until 2002, I thought that the academic approach to understanding the market was via efficient markets and CAPM. While writing the story, I realized that even within academia for almost a decade there were people calling this mainstream view into question. I immediately purchased “Capital Ideas,” read it, and then wrote the article. So that’s what got me started on this adventure. After the article, Harper Collins suggested that I write a book and I agreed. I then asked Peter Bernstein to lunch to get his blessing – I was essentially going to continue his story, but also at times contradict Bernstein’s message. Peter Bernstein was very supportive of my ideas, I was lucky to send him a final version of the book to review before he died earlier this year. I think Peter agreed that the story [of modern finance] was no longer a simple tale of the triumph of the ideas he related in “Capital Ideas.”
However, although I believe my narrative is very accurate until the 1980’s, I’m not so sure as to how history will develop thereafter. It’s very hard to know which papers (from the 1980’s until present day) will be cited for decades and thus shape “modern finance.” For example one person who almost completely fell out of my narrative is Andrew Lo of MIT. Professor Lo has done quite a bit via his adaptive markets hypothesis. Instead of Lo I focused on Andrei Shleifer from Harvard, but I just as easily could have mentioned Lo. Luckily John Cassidy of the New Yorker has a new book called “How Markets Fail.” It covers’ some of the same aspects of my book, but it also goes into other markets besides financial ones. Cassidy cites Andrew Lo, Jeremy Stein, and many other modern contributors which will present a very interesting narrative.
You came across all these bright minds – were there any academics that stuck out and that you admire particularly?
I’m inspired by Eugene Fama, the author of the efficient market hypothesis. After publishing his efficient market paper in 1970, Professor Fama worked on different areas besides financial markets for the next 15 years. Then as articles began to question efficient markets he started testing the hypothesis with Kenneth French. Fama basically tore apart much of the structure he helped construct in the 1960’s. He’s never completely abandoned the idea of the efficient market, but he has been able to define it to the point where it’s not as unreasonable. He is willing to admit that market prices can go wrong and stay wrong for extended periods of time. He is still very dubious of anyone who claims they are outperforming the markets. Essentially, Fama kept testing his idea and when it didn’t hold up he modified it. To me this is very admirable.
Besides Fama, I’m currently very entertained by the rebels – that is non-efficient market believers – such as Richard Thaler & Robert Shiller. Larry Summers was a rebel as well, but he left academia to run the world, so to say. I loved learning about all of these people. I even loved learning about Irving Fisher. I don’t know if I would have enjoyed spending much time with him, but Fisher had one of the most fertile minds of any economist. He had ideas in the early 20th century such as inflation-linked government bonds, index funds, and stock market indices. Fisher also had an idea that we should have a global currency linked to a basket of commodities. So in essence I loved learning about these people and I try very hard in my book to present their ideas.
How do you explain for the mainstream taking so long to debunk the efficient market theories? Do they just have to teach something in business schools?
Yes, I think that’s part of it. I recently had an interesting experience at Columbia Business School. I was giving a speech titled, “Should finance professors take the blame for the financial crisis”-my conclusion is that it wasn’t their fault, but they should take some of the blame and reexamine what they are teaching. There was an MBA student who previously studied history and noticed that finance was generally presented as a science with great truths; whereas in many other areas, even economics, ideas were not presented with such fervor. It just so happens that Joel Stern, another member of the audience and a Chicago MBA from the 1960’s (who was a great promoter of these ideas, first at a division of Chase Bank and then at his own firm, Stern Stuart) responded by saying that, “the papers of Modigliani & Miller were the beginning of finance as a science.” It was fascinating to listen to the discussion unfold.
So I think the ideas are in mainstream because they are easy to teach. Also, many of these peoples’ self worth is bound to these ideas being understood as hard science. Yet, these ideas have been useful in many cases. In the case of Joel Stern, he has used modern finance to give good advice to many companies, such as paying less attention to earnings and more to cashflow. This isn’t different than what a typical value investor would recommend.
You beat me to the next question. There’s a saying that all models are wrong, but some models are useful. What do you identify as the limits to the Efficient Market Hypothesis & related theories?
First, I would say the argument that you can’t beat the market unless you have inside information. It completely misses why value investing works- value investing works because it’s hard to stick to as a professional investor. To practice value investing you must be willing to be out of fashion a lot of the time. So yes, it’s hard to beat the market, but there are approaches that work. The reason these approaches work has to do with the structure of the investing industry and human nature (and emotions).
There is another idea which isn’t identified directly in academic research, but it goes as follows: “the more resources you throw at trying to beat the market, the closer to perfection market prices will get.” I think this is a real misconception. In reality, you can get to the point where you are throwing so many resources at anomalies that although one anomaly disappears others arise from this overallocation of attention. Doyne Farmer, a physicist at the Santa Fe institute who has become a semi economist, likens it to the fluctuations of predator and prey.
A group of predators keeps growing to the point where the predators eat too many of the prey and then the predators start to die off (due to a lack of opportunities). As the predator population dies off, the prey population grows, and then again the predators start to
To apply this to finance, the market anomalies are the prey and the hedge fund managers are the predators. And so you have a natural fluctuation that does not bring us closer to equilibrium, but rather causes market fluctuations.
You mention Andrew Lo and the “Adaptive Markets” hypothesis. It seems to us like finance has ended in this theoretical culde- sac. Have you come across any alternative theories that have expanded the field or are we expanding the “current” paradigm at the expense of developing another one?
I would say that we are still expanding the current paradigm. I don’t know if it’s at the expense of developing another paradigm. Ever since the development of chaos & complexity theory there has been hope that it could be applied usefully to finance. So far applying these new theories has had limited success.
There’s been this tendency among journalists who look at complexity science over the past 20 years. They visit the Santa Fe Institute and claim this is the new paradigm of economics and they’ve solved everything. But this just hasn’t happened.
I have to ask an economics question, are there any institutional economists left?
A lot of people call this year’s Nobel a win for the institutional approach. So, institutional economics hasn’t disappeared, but it shows no signs of reclaiming the mainstream. Institutionalist economics was in the mainstream in the 1920’s-1930’s and associated with Wesley Mitchell, but he had no idea of what to do during the depression so it seems to have lost ground.
The institutionalists have a hard time quantifying their ideas.
Right, institutionalists are brilliant writers and observers of markets. For example, John Kenneth Galbraith was a brilliant critic of orthodox economics, but Galbraith didn’t have a coherent alternative. There are some like his son, Jamie Galbraith, who would argue that we don’t want a coherent alternative; we should just accept that economics is not a science and be more like a comp-lit department. Personally, I don’t see many economists wanting to go down this route. I think most finance professors and economists do very useful work. Much of the work of finance professors (and economists) is more useful the more narrow and specific the questions are. So yes, they fail at macro levels, but at micro levels they are useful.
In your book you profile Robert Shiller. Can you tell us about the Shiller paradox?
Sure, he doesn’t think it’s a paradox when I brought it up with him. Shiller has made his name by documenting how markets depart from fundamentals. His work shows that markets are more volatile than any purely rational market would be. He started this in the 1980’s and it led to some of the other things he has done such as his real estate market index. Shiller reminds me a lot of Irving Fisherin that he keeps coming up with these wonderful ideas to measure economic reality and hedge against risk.
What really strikes me is that here’s a guy that’s documented that markets have an ingrown tendency to overshoot. And he thinks the solution is to create more financial markets. I have run this by him, but he doesn’t think this is a paradox; rather, Shiller thinks that innovation leads to a better financial system. I think at some level that’s true, but it’s clear that in finance a high percentage of innovative ideas turn out to be bad ideas. I can only compare this innovation to pharmaceuticals, but even there innovation is tested to weed out bad products.
Everyone promotes growth for the financial sector. Are there any diminishing returns to such large financial systems?
I addressed this issue in a recent column. There has been remarkably little research in this area. Thomas Philippon (at NYU’s Stern School) has made this his project for the past couple of years. Philippon has documented the different size of the financial sector relative to GDP. What he finds is that there are three periods were the financial sector ballooned as a percentage of GDP: the late 19th century, the 1920’s, and the 1980’s-1990’s. Those were all periods in which new companies were in desperate need of outside financing. The railroads & utilities (in the 1800’s), all the large manufacturers (in the 1920’s), and the tech companies (in the 1980’s -1990s). By this argument, it would make sense that the financial sector would grow to meet the demand for financing these companies. But what he also finds is that after about 2001 there is no longer a great demand from corporate America, yet Wall Street didn’t shrink. In retrospect, this seems like a case of Wall Street firms desperately trying to maintain their size & in the process doing some pretty stupid things.
Philippon and his colleagues are also looking at wages in the financial sector and finding that between the 1930s-1980’s people got paid much less than other sectors in the economy when controlled for education & skill levels. This changed in 1986 and over the past decade if you were in the financial sector you got paid 30-50% more than somebody in any other part in the economy with the same skills and training. Their argument is that this might be some sort of windfall that might be counterproductive. Essentially, such a dislocation is pulling people out of productive sectors of the economy and steering them into Wall Street. The problem is that it’s hard to pinpoint when the financial sector got too large and, correspondingly, what percentage the sector should control. It’s very clear based on the recent past that the prosperity of Wall Street isn’t linked to the prosperity of the rest of the economy. Most people knew of this conflict, but many professors didn’t research the idea. Incidentally, there’s much research showing the importance of financial sectors in developing countries. But this research can’t be used to conclude that you need ever larger financial
sectors [in developed nations].
This has been a deep crisis and I hesitate to say that it’s over. How were you surprised? Are you surprised by the actions within the financial sector – particularly the banks?
Right now, we are seeing that financial firms that managed to survive are taking advantage of what the Fed is doing and snatching up market share. A month ago [September], I would have bet that the financial institutions would have gotten away with this, but I think there is a huge political backlash brewing.
So what we have done is further consolidated the system. Much depends on whether this consolidation results in a growing or contained financial sector. If the consolidated sector starts growing again, then the question going forward is: are we heading for another crash (down the road)?
How did you examine the housing crisis. Furthermore, how did the efficient market theories play a role in allowing the housing crisis to develop?
It’s funny because none of the papers were citing Eugene Fama and using the word efficient markets. But there was a real tendency to back off from anything that would say these mortgage markets are out of control. There is this one paper that was very clearly aimed at denying Shiller’s claims of prices “reverting to the mean.”
Greenspan himself was aware that something was going on. I thought it was wonderful that he coauthored several papers on home equity extraction. But Greenspan would always pull back on the notion that we had great derivative markets and securitization markets that were spreading risk. So no one ever said I’m not going to do anything because markets are perfect. But, decisions (by central bankers and authorities)were informed by the sense that it wasn’t only banks doing these things but rather markets who were particpating so things were okay.
As I’ve read your book and studied modern financial theory, leverage doesn’t seem to be factored into these theories. Why has modern financial theory ignored leverage?
This is the most amazing omission of modern finance. If I had started writing the book deep into the financial crisis I would have focused on this issue. Clearly leverage and lending changes risk; one minute you can pay and the next minute you can’t. With equities this isn’t as much of a problem because there is a continuum of potential payouts. Bond markets & leverage oriented markets don’t work that way and the core of financial theory doesn’t cover this concept.
I heard a story of someone asking Eugene Fama about Minsky of which he had never read. This leads me to ask, what is your take on the tunnel vision of most PhDs?
Fama is very extreme in that sense. He does his work and doesn’t see himself as a freelance intellectual opining about everything in the world. He sees himself as someone who is a borderline expert in this narrow area. That’s how academia works. In economics, people who try to explain things to the general public are looked at with suspicion by their colleagues (be it Krugman or Steven Levitt). Many people see that as a step down. I guess it makes sense for some people to have their nose to the grindstone, but I did notice that story. In fact, I believe Fama was saying that in response to having read my book. That is to say he read my book, but not Minsky’s. I think that might be a bit misplaced.
Paul Krugman to his credit has spent the last six months obsessed with Minsky’s work. Not all the answers are in Minsky, but maybe we should incorporate some of the ideas of the credit cycle into how the economy works. So it’s nice that Fama is honest, but I don’t see why he wouldn’t be interested in other concepts & topics.
I know you are aware of investors like Warren Buffett that have outperformed the markets. How do you see their success? And after studying modern financial theory, what would you tell value investors?
Buffett is a very capable investor who possesses certain behavioral traits and skills that make him a very good value investor. There is another part of his success that doesn’t get focused on: one of the reasons value investing is so hard is that there are periods when you are the least fashionable person out there – when everyone wants to take their money out of your fund and put it with the latest tech fund, etc. Buffett has set himself up so no one can take their money out. People can sell their shares, but Buffett doesn’t care – he is financing all of his investments out of the cashflow of the businesses he owns.
I might add that he would probably prefer for his shares to fall so he could purchase more of them.
In the mid 1970’s when he was making the investments that made him the mega billionaire that he is, Berkshire Hathaway stock was dropping. If Buffett had been a mutual fund manager he would have lost investors during that entire period. Sure, earlier on he had a hedge fund with a lockup and he knew the money could flow out at any time. To a certain extent, Buffett got very lucky that he never had a negative year. To his credit he saw bad times coming and he returned everyone’s money.
What’s your definition of risk?
The common sense definition is what can go wrong. The finance version of risk being variance is not totally useless, but you need to be aware that past variance doesn’t say anything about the future variance.
What people need to realize is that Harry Markowitz was originally trying to develop a systematic way to think about decisions that investors make in assembling in a portfolio. These (variance, etc) are the tools he had and they aren’t the worst in the world, but the movement carried his ideas beyond that.
I had an interesting conversation (and this doesn’t appear in the book) with Clive Granger who won the Nobel 2-3 years ago [in 2003, actually] for economic work unrelated to finance. He told me that in the 1960’s he was heavily researching the random walk theories, but he pulled away in the early 1970’s because he felt that all of these finance guys misunderstood risk.
Let’s talk about your top blog, “The Curious Capitalist.” How do you balance being a journalist and a blogger? What do you enjoy?
The main thing I enjoy is the freedom. My blog is much more “highbrow” than my column. When I write for the magazine [TIME], it’s going to be in the dentist’s office. I had an interesting experience during a cross country trip where many of my cousins would tell that they read my column, but couldn’t understand the material. I found it interesting that intelligent people who didn’t follow the business would find it so hard to follow. So my blog is targeted towards more sophisticated readership and I can explain things via comments. It’s much easier to write the blog. The thing I hate about the blogs is the relentlessness of it. I was spoiled when I left newspapers and went to Fortune by not having to write as often.
I’m really torn right now, I feel like I spend more time on the blog than anything else. I don’t know if that really makes economic sense.
What business & financial topics interest you going forward?
I’m very interested in the topic of risk. There are many subjects that I would love to immerse myself in and write a long article about, but they aren’t right for TIME. I’d love to talk about securitization, credit default swaps, and market to-market accounting. When you write a book you are sick of the subject by the end of it, but doing interviews has gotten me interested in the subject again. Overall, I’m not sure if I want to do more of this type of writing.
You’ve spent quite a bit of effort and time on this book. I would argue that perhaps you are the one that deserves a PhD in finance.
They won’t give me one. [laughter]
Justin, thank you for joining us.
For more information visit: www.ByJustinFox.com