Myth of the Rational Market: the rise and fall of the idea of market rationality

Justin Fox's The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street is a book that chases down a provocative debate that the author discovered while working for Fortune magazine: the idea that the market is driven by fear, psychological quirks, fads, and other "irrational" factors, and as such, it does not represent a set of prices derived from the decisions of millions of actors, but rather a set of nearly impossible to predict fluctuations that are about as useful as a series of coin-tosses.

This hypothesis is a timely one, given the recent econopocalypse, but readers who (like me, I admit) turn to the book to find a snarky excoriation of the idiocy of the rational market ideologues who got rich while annihilating the economy will not find it here. Instead, what Fox has put together is a thoughtful, often fascinating, always illuminating history of the idea of market rationality, and the fortunes of the economists, bankers, regulators, philosophers and psychologists who've sought to explain the stormy seas of the market (and to get rich while doing it, of course).

If you've followed the behavioral economists and the exciting, weird and difficult-to-generalize conclusions they've reached since the crash (or the last one), Myth is a good grounding in the ideas that behavioral economics reacts against: the notion that a small group of fast-moving, informed investors can keep the market rational by exploiting the idiots and the suckers and the weirdos, taking all their chips and sending them away from the table.

Myth considers "rational" explanations for bubbles and crashes -- the fact that CEO and fund-manager compensation is structured such that a "rational actor" will do things that make the market go blooie -- and also the most pervasive "irrational" economic factor: overconfidence, which seems to be at the root of many, if not all, of the market's oddities.

By the end of the book, I was left with a much clearer understanding of how little I understood: how much of the technical jargon and specialized jargon of finance serves as window-dressing on a bunch of unproven and half-proven ideological assertions, and how little there is in the new "science" of behavioral economics to explain all of it (yet).

The overwhelming conclusion I came to when it was all done was this: if I was starting out at university right now, I'd go into behavioral economics and see what there is to be seen. It's a new territory, rich and barely mapped, and there's plenty to discover there.

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street


  1. I think what you’re trying to say is that the invisible hand of the market has hairy palms.

  2. Also, could someone who understands URL’s and Amazon explain why the URL to The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street ends with “downandoutint-20”????

    If I take downandoutint-20 off the end of the URL I still end up going to Myth of the Rational Market.

  3. It’s my Amazon affiliate ID. By including it in the link, I get a commission if you buy the book.

  4. “It’s my Amazon affiliate ID. By including it in the link, I get a commission if you buy the book.”

    Ahhh… so is it considered rational to post a glowing review of a book you have a vested interest in people buying? Or is it irrational for people to assume you are not in it for the money?

  5. Wow, I liked that phrase so much I had to write it up:

    When you hear “invisible hand of capitalism”, you should immediately imagine some laissez-faire capitalists masturbating to some economiic porno with “Bow chicka bow wow” replaced with “cha-ching cha-ching”.


  6. @5: Good question. From my perspective, I don’t have the patience or time to read books I don’t like well enough to recommend (except under extraordinary circumstances, as when researching for a novel), so I only write up the books that I enjoy.

    Up to you to decide the extent to which you trust my judgment of course. I figure it’s a little like Zagats having a side business in selling “REVIEWED IN ZAGATS” stickers to restauranteurs. Technically, the more restaurants they give glowing reviews to, the more of these stickers they sell; but I still trust them because I figure they’re in it for the long-haul and would rather the long-term revenue of satisfied readers than the short-term hit of sticker sales to inflated restauranteurs.

  7. I believe it was mathematically proven over a century ago that capitalism is inherently unstable. Booms and busts are inevitable. The Greater Fool Theory is also very old.

    And yet for all it’s flaws and weaknesses, capitalism still has a better track record than any other system.

  8. Is the author careful to make the distinction that the current market is not a “free market”?

    I agree with a lot of what’s mentioned in the summary. Very true, CEOs are incentivised to induce stock price fluctuations vs longterm development of their business.

    That said, these are not the results of the “free market” as at the root of all this is a command and control money supply as well as (in the case of volatile stock prices) extorted funds in the form of tax-free/reduced retirement money not being managed by the actual investor – leading to an unnatural level of liquidity allowing fund managers to partake in self-actualizing trading.

    The invisible hand is legit, unfortunately it’s been holding a giant invisible gun to our heads for a hundred years.

    Ignoring these points is why much of traditional and behavioral economics is a study of the conditions created by non-voluntary means and therefore basically silly. If a scientist were to study chimps in a zoo and say that “all chimps are constantly hysterical and fling shit at onlookers” the first response most people would have is “you’re talking about a chimp in a cage, not chimps in general” – well that’s what behavioral economics does for the most part. If you ignore the fact that we’re in a cage then it seems logical that free markets and voluntarism cannot work.

    But we are in a cage…

  9. “In the short run the market is a voting machine. In the long run it’s a weighing machine.” — Ben Graham

    IOW irrationality can take over for weeks, months, and even years, but over the long term (decades) the market is rational. So buy a diversified basket of index mutual funds (of both stocks and bonds), and then forget about them. Even better is a “target retirement” fund that handles all this for you.

  10. @5: I see it this way – Cory would be recommending the book either way, so he loses nothing from adding his affiliate ID to the link. You lose nothing from purchasing the book with the affiliate ID, either, so there’s no loss on anyone’s part from Cory’s use of it. Economics!

  11. I’ve read a number of books recently on market hijinks. Rather routinely firms take arbitrage risks involving very large positions of hundreds of millions of dollars. Sometimes they pay off handsomely and sometimes they crash and burn. The failure of LTCM was brought about by a huge position in Russian bonds that went into default.

    While I’ve never been an enthusiast for communism or even socialism I must admit Marx certainly described the problem we’re in now over 100 years ago.
    From the Communist Manifesto:
    It is enough to mention the commercial crises that by their periodical return put on its trial, each time more threateningly, the existence of the entire bourgeois society. In these crises a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity–the epidemic of over-production.

  12. If only we could replace that nasty irrational market with a highly rational institution such as government, that does highly rational things like: throwing non-violent recreational drug users in prisons, mandates creationism in state run schools, invading countries because of non-exist weapons of mass destruction, banning speech that certain religious groups might find offensive, and I am just discussing recent actions by the U.S. government (therefore, ignoring Nazism, Stalism, and all the horrible wars and mass murders and genocide committed by governments).

    Perhaps it might be more fair to say: People are often irrational. People participate in markets. Therefore markets are often irrational. Duh! That doesn’t mean that democratic governments will be any less irrational.

  13. “If you’ve followed the behavioral economists and the exciting, weird and difficult-to-generalize conclusions they’ve reached since the crash (or the last one)”

    Hands up, I haven’t – so where would be a good place to start reading up on behavioural economics?

  14. all will be clear – in another thousand years. Humans just have to slow their war-making down to match their pace of economic learning.

  15. The main contradiction between market myth and reality is that the myth depends on the existence of a multitude of individual decision makers, whereas in reality, the disposition of the great mass of money is controlled by a few fund managers for very large pension and investment groups. This herd of elephants tramples all the smaller movers underfoot. And they are afraid of mice.

  16. @8 – Loling at your comment. The irony of it is that your comment goes against all behavioural economic theory.
    For the most part, I agree with you, no big deal. Just thought it was an ironic situation and your comment made it more so.

  17. I think child psychology would be most appropriate to apply–the desires, demands and rationalizations that are exhibited by Wall Street would make Nanny 911 rise up in high dudgeon if she were told them by a spoiled 5 year old. Cake and Ice Cream for Breakfast? We deserve it! Stay up all night? We’re fine! Have to eat our vegetables and do as we’re told? Waaaaaaah!

  18. …so where would be a good place to start reading up on behavioural economics?

    Crooked Timber is a good place to start. John Quiggin is reviewing all sorts of failed economic ideas and explaining in very lucid prose why they failed.

  19. @12: what distinguishes behavioral economics is that there is very little theory at this stage: the idea is to study what people actually do, and build theories from that, rather than start from unsupportable axioms and ideology (for example, that market participants are rational actors who seek to maximize a utility function) and try to turn the ideology into mathematics like most economists do.

    It’s the only part of the field that deserves the label “science”, but it’s very young and can’t say much yet.

  20. Yep – Behavioural Economics is the one. Phenomenal the insistence of the economic academia that the rational agent exists. Financial Traders know it’s a croc, and know that the market believes it, so find one arbitrage strategy in there.

    i.e. they know perfectly well they’re screwing the world.

    And for informed, educated persons, behavioural economics is not that hard. It’s about nous.

  21. @19 (Keith)

    John Quiggin is a talented economist but I would hardly call him a behavioral economist. I studied behavioral economics in college and the names you want to look out for are Richard Thaler, Daniel Kahnenman, Dan Ariely, etc. I would start by reading “Predictably Irrational” by Dan Ariely, or “The Winner’s Curse” by Richard Thaler — the first is easier to read for someone new to the field, while the second is a classic in my mind.

  22. I have a friend who helps out at our local parent participation pre-school. She also runs an investment fund. In the last 3 years, she has seen only gains. This was after she started investing in the market with the view that all corporations and the people running them have the moral compasses of toddlers.

  23. #25, your comment is insulting to many toddlers. I’ve knows slime molds with a better understanding of morality than CEOs and their boards…

  24. Markets are the most useful tool we have for distributing many resources, but there’s a significant difference between being pro-market and pro-business. Most of the republitards who claim to be the former are actually the latter.

  25. @Cory Doctorow #7:

    …I don’t have the patience or time to read books I don’t like well enough to recommend (except under extraordinary circumstances, as when researching for a novel), so I only write up the books that I enjoy.

    How do you know which books you’re going to like before you read them?

  26. Thanks for the tip Cory and of course you are entitled to your freely disclosed commission. I have ordered the book to be sent to my local bookstore in Sydney, so about 4 weeks wait – an example of information lag that puts even relatively advanced places like Australia at a disadvantage.

    There has been a lot of writing about behavioural economics, or perhaps mob psychology, and I think it is fascinating. It is clear that markets are not merely random – the swelling of the sub prime mortgage market was clearly a unified collective impulse, not just the random act of a plethora of individuals. Similar statements can be made about the dot com boom and the tulip boom in (about) the middle ages in Holland.

    The difficulty, of course, is that we can see such an impulse happening – lots of people were saying the subprime thing was whacko well before it fell over – but it is hard to tell what will tip the balance and spook the herd in another direction.

    I look forward to reading the book and thank you for the tip.

  27. This myth of the market is the backbone of the Republican party, and also part of the myth of the American economy. It has been for decades. Republicans co-opted the inherently moral traits of capitalism (ie, EVERYONE aiming to do their best and accepting wins and loses) and a laisez-faire economy and branded themselves as the good guys against anyone who disagreed. In the beginning of this “campaign” the enemy was naturally the communists, and a grand narrative was created with lines drawn in the sand: republicans were capitalists, democrats (against capitalism or they’d be Republicans, right?) were the socialists.
    The party and its backbone were severely weakened during the Bush 2 years, with the cracks showing in their corrupted version of capitalism. Now that Bush 2 is a memory, they’re circling the wagons and using alpha male Cheney to reinforce the old, but still, false conventional wisdom that to be a Republican is to be a capitalist. Democrat? Then you’re the enemy of capitalism, socialism, then communism.

  28. The blind believers in the infallibility of the markets have always puzzled me. I took an econ class over 30 years ago that combined macro and micro into one 5 credit hour class. According to the classical economics taught then we would have unemployment even if our economy was 100% efficient, always operating flawlessly. Anyone who understands the concept of human fallibility knows that no system we have ever produced works that well. Yet those who claim to be so expert in economics and understand that it works so well somehow never seem to have heard that basic fact. They consistently blame everyone who is unemployed but not physically disabled for their status. It is a broad brush they paint with when condemning so many people on such a flimsy basis yet they never seem to hesitate about doing so.

    Most of what they believe in is similar to a physics class where you do basic calculations on the movement of an object across a surface without allowing for friction. It makes for a simple classroom exercise but bears little resemblance to reality because you just haven’t accounted for factors found in the real world.

  29. As I have argued to every libertarian I have encountered (after I am done rolling my eyes at their dangerous brand of naivete), the perfectly efficient market does not exist because it is based upon assumptions that are untenable in reality – perfect knowledge and transparency, rational actors and lack of externalities.

    I am glad to see some thought being put toward the way people actually interact. It seems infinitely more practical than using the “science” of economics as nothing more than a rationalization for a group’s political agenda. My thanks to Cory and the commentors for pointing out authors and titles on this subject.

    Oh, and @Bill Albertson: So, you know an investment fund manager that has seen nothing but gains over the last three years? Really? And is her last name Madoff by any chance?

  30. I’ve been saying this for years.

    Why buy stock in XYZ? Because you expect the price of the stock to increase. Why do you expect the price of the stock to increase? You believe that others will expect the price of the stock to increase.

    What keeps markets even nominally rational is all the wringing of rational instruments to try and make such speculation rational, because we want to believe that markets are rational and therefore predictable.

    It’s a shared illusion.

  31. @#32: Assuming that a natural price mechanism generated through individual arbitrage will be a more efficient means of allocating resources is not a more “dangerous brand of naivete” compared to the notion that a central authority has the knowledge necessary to allocate resources more efficiently than a natural price mechanism.

    I do not believe Libertarians espouse perfectly efficient markets, rather marginally efficient. Economics taught in colleges is a joke. You must not have read much Libertarian/Anarchist literature considering these groups have been stating this for generations. Command and control economic policies got us here as a non-cartel banking sector / currency monopoly based economy would have flushed out problems via competition and disallowed the asset value inflation we saw, which the government is attempting to sustain via monetary inflation(which amounts to theft).

    I’m going to go out on a limb and say you think Alan Greenspan was a “free market” guy…cause if you do…drawing board time on those strong opinions.

    If you like “behavorial economics” – that is economic understanding rising from the study of the individual – then you have more in common with a Libertarian’s eocnomic views vs the other party…whichever faction of it is in charge.

  32. @Brainspore & Clayton

    How do you know which books you’re going to like before you read them?

    I suspect Cory meant to write:

    …I don’t have the patience or time to review books I don’t like well enough to recommend…

  33. The Austrians have been saying this since the Great Depression (which the Austrians, of the time, are on record as having predicted. Mises in 1929: “A great crash is coming, and I don’t want my name associated in any way with it.”)

    A central tenet of Austrian economics is that “the economy” is the sum of millions of individuals making individual decisions according to their own preferences, and is not reducible to cute little equations based on the assumption that people are rational actors who always make rational decisions.

    Of course, no “mainstream” economists are willing to acknowledge that the Austrians have been right about this all along, so they pretend that ‘behavioral economics’ is something brand new, and not just a rebranding of what Mises called ‘praxeology.’

    Let me be clear: the behavioral economists are making excellent and valuable contributions, and I am not a pure Austrian myself, nor am I a Libertarian. However, I am struck by the intransigent refusal of the economic establishment to admit that they’re simply reverting to a fundamentally Austrian view of economics.

  34. Micro-economics and behavioural economics get along well together.

    But for the macro- and market effects, other factors come into play. In particular, network effects can show some of the same market outcomes, largely independent of the behaviours of the participants. (This is Santa Fe Institute territory.)

    Check out

    I find that as you work through his books and papers over the last few years, he has become less ranting and more readable. But I still enjoyed “The Death of Economics” from 1996.

    For the ultimate in network effects, go check out “Physics of Evolution: Selection without Fitness”, at

  35. What, no mention of NNT and the Black Swan?

    Was this an obvious comparison that was neglected or is Fox’s core message (market models are not reality) substantially different?

  36. The rational market controversy reminds me of those articles you see in popular science magazines once in a while: “Was Darwin Wrong?!?”

    Adam Smith’s invisible hand was a precursor to Darwin’s natural selection; the two phenomena are similar and prone to similar exaggerations and misunderstandings.

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