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Justin Fox’s The Myth of the Rational Market:Book Review

Justin Fox’s The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street(Harriman House, 2009) isn’t exactly hot off the press, but I discovered it only recently. It’s a fast-paced history, replete with interesting (sometimes chatty/catty) details, of theories about the financial markets from Irving Fisher to Robert Shiller.
The cast of characters is huge. I list them here to give a sense of the scope of the just shy of 400-page book: Kenneth Arrow, Roger Babson, Louis Bachelier, Fischer Black, John Bogle, Warren Buffett, Alfred Cowles III, Eugene Fama, Irving Fisher, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Michael Jensen, Daniel Kahneman, John Maynard Keynes, Hayne Leland, Robert Lucas, Frederick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Merton Miller, Wesley Mitchell, Franco Modigliani, Oskar Morgenstern, M.F.M. Osborne, Harry Roberts, Richard Roll, Barr Rosenberg, Stephen Ross, Mark Rubinstein, Paul Samuelson, Leonard “Jimmy” Savage, Myron Scholes, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Richard Thaler, Edward Thorp, Jack Treynor, Amos Tversky, John von Neumann, and Holbrook Working. (more…)

Misbehaving: The Making of Behavioral Economics-Book Review

MISBEHAVING-ASRBehavioral economics is now mainstream, at least outside of the stodgiest of economics departments. In fact, as the author writes, “This maturation of the field is so advanced that when this book is published in 2015, barring impeachment, I will be in the midst of a year serving as the president of the American Economic Association, and Robert Shiller will be my successor. The lunatics are running the asylum!” (p. 335) How behavioral economics got to this point from its humble, academically risky beginnings in the 1970s is the subject of Richard H. Thaler’s Misbehaving: The Making of Behavioral Economics (W. W. Norton, 2015).

Traditional economics studies rational agents, whom Thaler calls Econs; behavioral economics studies Humans. Econs are a construct designed to fit a theory; Humans are real people whose often irrational activities provide data (supposedly irrelevant factors) for study and hypothesis formation.

Thaler’s book, a personal history of the struggles and triumphs of behavioral economics, is also a wonderful introduction to the field. It recounts study after study that show just how predictably error-prone people are. And it explains how businesses can use these findings to keep customers happy and how governments can use them for the public good.

Looking back, Thaler suggests that the area where behavioral economics has had its greatest impact is in finance. “No one would have predicted that in 1980. In fact, it was unthinkable, because economists knew that financial markets were the most efficient of all markets, the places where arbitrage was easiest, and thus the domain in which misbehaving was least likely to appear.“ And yet these markets exhibited tell-tale anomalies, for instance the storied case of Palm and 3Com. Moreover, he notes, “It also didn’t hurt that financial markets offer the best opportunities to make money if markets are misbehaving, so a lot of intellectual resources have gone into investigating possible profitable investment strategies.” (p. 346)

The area where it has had the least impact so far is macroeconomics. In part, at least, this is due to the fact that the field “lacks the two key ingredients that contributed to the success of behavioral finance: the theories do not make easily falsifiable predictions, and the data are relatively scarce.” (p. 337)

Misbehaving is a thoroughly enjoyable read, not quite right for the beach but perfect for a rainy Sunday afternoon.

Irrational Exuberance

k6779Robert J. Shiller

Shiller’s book presents yet another correct view of the issues that so many people refuse to confront. These are the very issues that cause people to lose. Perhaps, one day investors will begin to appreciate uncertainty as something that can be managed. If people refrained from being overconfident or indulging in their magical thinking and then started to manage uncertainty as Trend Followers do — there might actually be the risk of no more trends!

Is it likely? No. For trends to stop investors would need to realize that news, personal opinions, tips, etc. have no relevance to properly making a decision. Trend Following trading takes advantage of the psychological weaknesses that most people possess. Trend Followers disarm the magical thinkers by winning their losses in the great zero sum game.

Ponder the wisdom:

Everyone wants to be rich, but few want to work for it.

7 Ways Your Brain Is Making You Lose Money

“Investors are ‘normal,’ not rational,” says Meir Statman, one of the leading thinkers in behavioral finance. Behavioral finance aims to better understand why people make the financial decisions they do. And it’s a booming field of study. Top behavioral finance gurus include Yale’s Robert Shiller and GMO’s James Montier. It’s also a crucial part of the Chartered Financial Analyst (CFA) curriculum, a course of study for financial advisors and Wall Street’s research analysts. We compiled a list of the seven most common behavioral biases. Read through them, and you’ll quickly realize why you make such terrible financial decisions.

Read. However, once you get the idea of behavioral finance, keep in mind that the names associated with this article don’t have a wise strategy. Trend following is wise. Predictions, forecasts and other la la statements about what might happen tomorrow are only useful if you are masochist.