Rational Markets: Yes or No? The Affirmative Case

With the recent flurry of articles declaiming the death of the rational market hypothesis, it is well to pause and recall the very sound reasons this hypothesis was once so widely accepted, at least in academic circles. Although academic models often assume that all investors are rational, this assumption is clearly an expository device not to be taken seriously. What is in contention is whether markets are “rational” in the sense that prices are set as if all investors are rational. Even if markets are not rational in this sense, abnormal profit opportunities still may not exist. In that case, markets may be said to be “minimally rational. ” I maintain that not only are developed financial markets minimally rational, they are, with two qualifications, rational. I contend that, realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. I also argue that investor irrationality, to the extent that it affects prices, is particularly likely to be manifest through overconfidence, which in turn, is likely to make the market “hyper-rational. ” To illustrate, the article reexamines some of the most serious historical evidence against market rationality. With the recent flurry of articles declaiming the death of the rational market hypothesis, now is a good time to pause and recall the very sound reasons this hypothesis was once so widely accepted, at least in academic circles. Although academic models often assume that all investors are rational, this assumption is clearly an expository device not to be taken seriously. What is in contention is whether or not markets are rational, in the sense that prices are set as if all investors are rational. Even if we conclude that markets are not rational in this sense, abnormal profit opportunities still may not exist. In that case, the markets may be said to be “minimally rational. ” I maintain here that developed financial markets are minimally rational and, with two qualifications, even achieve the higher standard of rationality. The philosophical basis for rational markets has a long and illustrious history. It derives from the ancient Greeks, was strengthened during the Enlightenment, bolstered by Darwinian evolutionary theory, and given its most profound exposition in the 20th century by Nobel laureate Friedrich Hayek, who saw the price system as an efficient and continuously functioning gigantic polling mechanism. Several factors lead to minimally rational markets—the self-destruction of profitable trading strategies, self-destruction of irrational traders, exposure of irrational traders by performance measurement, and cross-cancellation of irrational trades. The most telling reason, however, follows from the key type of irrationality emphasized in behavioral finance—investor overconfidence. Overconfidence leads to excessive investment in research and to market prices that are, in a sense, hyper-rational. This assertion is empirically supported by the long history of studies of mutual fund performance showing that the average mutual fund underperforms an index fund, thereby effectively squandering its research expenses. In addition, little evidence has been found that even one mutual fund has outperformed the average more than would have been expected by chance. The superior historical performance of U.S. equity index funds weighs heavily against the list of reported market anomalies because it is the result of actual, not paper or imagined, strategies. Nonetheless, the case for market rationality is even stronger if the most important reported anomalies—excess volatility, the risk-premium puzzle, the size anomaly, closed-end fund discounts, calendar effects, and the 1987 stock market crash—can be directly countered. This article tackles that challenge by arguing that the anomalies can be best explained within the hypothesis of market rationality. In some cases, the anomaly turns out to be an empirical illusion; in others, the models that fail to explain the anomaly contain unrealistic assumptions. For example, a key failing of most academic models is the assumption that investors know with certainty the characteristics of other investors in the market. This assumption, which has nothing to do with market rationality, needs to be dropped before the models can realistically explain the anomalies.