Financial Accounting Standards Research Initiative

I suspect you mean The Myth of the Rational Market, though Fox does suggest that academic researchers, and the bankers that relied on them, were not particularly rational men (or women). Here is an excerpt from the review at Financial Times:

Perhaps most scandalously, the theory remained received wisdom long after empirical and theoretical arguments had demolished it within the academic community.

Joseph Stiglitz, now famous as a critic of globalisation, published a proof that the efficient markets hypothesis was logically impossible because otherwise it would be irrational to spend money on research.

More startling is Fox’s story of the University of Chicago’s Eugene Fama, who promulgated the efficient markets hypothesis in its most widely recognised form by combining it with the capital asset pricing model that portrays investing as a trade-off between risk and return. The key risk, known in the jargon as beta, is the sensitivity of a stock’s price to moves in the market as a whole. According to Fama’s theory, movements in stocks are random, except that high-beta stocks will be more volatile.

But in the early 1990s, Fama and Kenneth French published a large empirical survey of stock market returns since 1940 and found several ways in which returns were not random and which could not be explained by beta. In aggregate, smaller companies did better than larger ones, while “value” stocks, which are cheap compared with the book value on their balance sheet, also outperformed. There was even a “momentum” effect – stocks that had been doing well for a while tended to continue to do so.

Fox makes clear that this was tantamount to the founder of efficient markets admitting his theory was wrong and quotes the judgment of one critic: “The Pope said God was dead.” He is also scathing about Fama’s attempt to rescue the theory by categorising all these effects as “risk factors”. For example, a cheap company with a high price-to-book value was risky, and hence it generated higher returns for its investors. “This amounted to saying that the same company was a riskier investment at $5 a share than at $20 – a bizarre contradiction of the teaching of successful investors.”

All of this came more than a decade before last year’s implosion. So why did regulators continue to enshrine assumptions of efficiency in the rules they set? Fox points out that as early as 1974, efficient markets theory was embedded in US pension regulations; “No longer a legal concept based on tradition, prudence was redefined to mean following the scientific dictates of modern portfolio theory.” And why were investors prepared to risk so much on such a sketchy basis?

I believe that relaxations of the Efficient Markets Hypothesis help us understand markets better than a pure EMH does. But I find it a stretch to say that the small predictive power of Beta and slight inefficiencies (like Momentum) had a whole lot to do with banks taking on extreme degrees of leverage, which they did because they could keep their newfangled liabilities off their balance sheets.

Still, I am sure it is a good read. I’d love to hear from anyone who has actually read it.

I read it this past weekend. It is VERY VERY VERY GOOD!!!! It is a historical account of how behavioral economics/finance came to be .. it’s more oriented to economics (for those who have fears of “too much of that behavioral stuff.”) It was extremely interesting. I highly recommend it.