JUSTIN FOX, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (New York, NY: HarperCollins Publishers, 2009/11 (paper), ISBN 978-0-06-059903-4 (paper), pp. xvi, 390).
Is modern finance theory and in particular the efficient market hypothesis (EMH) to blame for the financial crisis, as Justin Fox's provocative title suggests?
While the title may lead one to that impression, the book is more than a cheap shot across the bow of the giants of the finance academy. Instead, I found a more considered reflection on the development of finance thought and the contribution of finance theory to financial markets.
The historical description of the breakthroughs in finance starts with the beginnings of Wall Street and the Great Depression. The collection of market data, blended with statistics, mathematics, and economics, to better understand stock prices is traced, but doubt is created by evidence from behavioral finance and boom and bust cycles that seem to run counter to the notion of market efficiency. The contributions by Fisher, Modigliani and Miller, Samuelson, Markowitz, Sharpe, Fama, Jensen, Black and Scholes, Greenspan, Shleifer, and Thaler are enriched by skillful interviews, research, and detailed endnotes.
This approach provides an ideal way to engage the reader to better understand the importance and development of ideas such as the efficient frontier, the irrelevance of capital structure and dividend propositions, the capital asset pricing model, option pricing models, behavioral finance, and to a lesser extent advanced quantitative modeling. It is an approach that encourages the reader to think about the role of finance theory, its contribution, and its shortcomings.
Fox provides detailed insights into how such developments would lead to radical changes in the role of portfolio managers, stock brokers, information, the creation of derivative markets and index funds, and the rise of the EMH. Add to the story the rise of the power of computers, accessibility to data, the growth of the world's economies, and the ever-increasing set of new tools to hedge (or gamble) on risk and you have the backdrop for a compelling, historically rich story made potent by the fallout from the global financial crisis.
The book is written with style, displays insightfulness, and provides important messages. Occasionally he moralizes on the issues, but his goal of being fair is generally met.
There is a history of such books. Personalize the key players, provide insights into their journey and their mentors, supplement this with some personal details to add color, and outline the role they played in the development of finance. Give a sense of discovery; highlight the complexity of the problem, drawing insights from other fields. Next show how the jigsaw comes together with the resolution of mathematical riddles that form the backbone of new theories. Showcase how the availability of new data and computers validate or cast doubt on these theories and how this evidence can overcome incorrect intuition.
Add intrigue as winners and losers emerge in the market for ideas, but cast ever-growing seeds of doubts with every unexplained shock in real-life markets. The shocks continue but still carry insufficient weight to strike down the growing dominance of academics' insights. As long as the finance that is taught in the business schools appears to work, these insights continue to be treated as holy writ.
Finally, a crash or scandal happens—so large, that it is impossible to ignore, and it is one that politicians and regulators are ill equipped to resolve. Media commentators, lobbyists, and finally Main Street demand action, and we experience a range of responses, some promoting moral hazard or corporate welfare, but all sold as necessary to ensure the stability of our financial system. Eventually, these events become a history lesson, the pain diminishes, and it falls to a new generation to be responsible for understanding, and not repeating, the follies of the past. Nevertheless, the current generation is still capable of complacency—we continue to hand down the commandment of “equity will outperform bonds,” despite not adequately understanding the equity premium puzzle. We continue to practice “quantitative management,” despite not understanding the triggers signaling when information, prices, or hedges become unreliable. In such an uncertain environment, can we trust our regulators, auditors, or rating agencies in a time of crisis?
Thankfully, Fox provides a detailed and carefully crafted story to remind us of the progress and problems so far.
The first main character outlined is Irving Fisher, and anecdotes about overcoming the loss of his almost-completed manuscript start our journey to understanding the rational behavior of markets. Fisher's suggestions in the 1920s of inflation-linked bonds and stock market index funds would wait until the mid-1970s to be fully developed. A giant in neoclassical economics, Fisher's road to influence was a rocky one. While he observed that there was safety in diversification, he miscalled the 1929 Crash when he uttered earlier that year that stock prices had reached “what looks like a permanently high plateau” (p. 24). Fisher loses his reputation and a personal fortune, in part by not diversifying. It would be 1954 before the market recovered to that level, and Fox reminds us through the book not to become complacent, no matter how much we think we have tamed the markets.
The re-emergence of Fisher's academic reputation would also take time, but his mathematical approach to finance and his call to free up the money supply after the Great Depression would become some of his major contributions to modern economic and finance theory.
Macaulay's coin-tossing experiment (p. 50) together with Working's 1932 insight that the failure to forecast stock prices “reflect[s] credit on the market” are the early beginnings of the EMH, but it would be some time before these gems received closer scrutiny.
Fox traces the development of Markowitz portfolio theory as he is guided and eventually succeeds in creating an idea “that would transform investing” (p. 55). Milton Friedman would challenge Markowitz in his Ph.D. defense. There was never a question of failing, just that it was “not economics; it's not mathematics; it's not business. It is something different. It's finance” (p. 55).
To his credit, Fox has the ability to lead us through the progression of ideas, from explaining who was standing on the shoulders of the previous giants, to describing who was encouraging their students to push the boundaries of knowledge.
Next, Modigliani and Miller's influence in transforming finance from “a field of empirical research and rules of thumb to one ruled by theory” (p. 75) is introduced. The Modigliani and Miller capital structure propositions “generated impassioned critiques” (p. 83) and were to inspire a new wave of academics such as Jack Treynor, William Sharp, John Lintner, and Jan Mossin, who developed versions of the capital asset pricing model.
The rise of The University of Chicago from its beginnings as a “lonely outpost” to become a dominant academic powerhouse today is richly detailed. The introduction of computers and new datasets, alongside the conversion of investment practice into research theory, combined with the influx of talented quantitative researchers who were influenced by Chicago legends such as Milton Friedman. These led to powerful new ideas being empirically tested. By 1963, the term “random walk hypothesis” had entered the vernacular—initially by a skeptical economist. Paul Samuelson's mathematical proof to link rational markets and random stock prices marked the beginning of the EMH that Harry Roberts and Eugene Fama would develop. These developments would ignite a drive to test the theories, and Fama, Fisher, Jensen, and Roll would introduce the “event” study by the end of the 1960s.
The book primarily focuses on finance, and Fox largely ignores the role of accounting information in financial markets. There is little mention of the giants of accounting academics who also emerged from Chicago, names such as Ray Ball, Philip Brown, Bill Beaver, and later Ross Watts.
The ideas of finance academics taking hold on Wall Street is a remarkable story. Some examples are the acceptance of portfolio theory, asset pricing models, the rise of the index fund, the need to systematically collect data to test the theories, and the massive rise of derivative trading due to option pricing models developed by Black and Scholes, and Merton and Roll. Such success is also tempered by examples such as the failure of portfolio insurance to hedge stock market risk and the fallout from Long Term Capital Management's inability to cover its positions. Jensen's influential work on the theory of the firm is also presented as extending market discipline to the firm.
Fama and Jensen will feature throughout the remainder of the book, but the later chapters will focus on the rise of behavioral finance and insights that challenge the EMH. For example, Richard Thaler's work on challenging the notion of efficient markets and rational choice models is followed by Chapter 11, titled “Bob Shiller Points Out the Most Remarkable Error,” which refers to Shiller's famous quotation arguing that observing no patterns in stock prices is not the same as stock prices being right. The response to such challenges is portrayed as one where the EMH definition shifts due to counter-arguments being made. In addition, some previous supporters concede that market anomalies do exist, and this is accompanied by the rise of work such as Andrei Shleifer's “noise traders” research. There is now a significant body of literature that highlights that individuals do not always behave rationally. That does not mean one can exploit this behavior consistently—particularly if you are a large investor.
Toward the end of the book, Fox crafts a debate between Fama and Dick Thaler, and Fox makes it clear that the ground has shifted. However, those who are preaching the demise of the EMH perhaps do not understand that, while the prices may not always be “right,” the recommendation to buy an index fund is still good advice, as “markets are hard to beat” and still harder if you pay someone to manage your portfolio (p. 306). Furthermore, Markowitz's diversification principle holds, and “[s]tock prices contain lots of information” (p. 307).
Understanding the powerful forces that make current prices hard to exploit consistently is one key lesson. On the other hand, understanding when prices can be manipulated is equally important. The collapse of financial markets requires us to consider what went wrong. We should not assume ….
The book encourages the reader to not only acknowledge the genuine benefits afforded by theoretical advances in finance, but also to understand the limitations to theory.
Fox is able to provide compelling evidence of the developments and shortcomings of the past, moralize about the issue, and conclude that, despite much progress, we have much more to learn.
Is Fox blaming the EMH for the financial crisis? He gives enough hints for others to draw that conclusion. In spite of this, this remains a book that provides a balanced discussion. For example, he acknowledges that stock and bond prices do convey information, are hard to beat, and that many in Wall Street never accepted the EMH. He also outlines Shiller's repeated warnings of irrational exuberance and that by definition the EMH could not predict such an event (prices are random). Academics have also long acknowledged that the EMH is a theoretical concept; otherwise, incentives to analyze information would not exist.
So, while Justin Fox's book is fair, balanced, insightful, and highlights the need to continue to understand why markets may or may not be efficient, I found some of the commentary around the book were more critical of the EMH.1
It is as if the critics believe the proposed theory was accepted beyond question. Post-earnings drift is shown in Ball and Brown's 1968 paper. Agency and positive accounting theory highlight the role of incentives, information processing costs, and moral hazard. Active investors never believed in the EMH, and lessons from behavioral finance have been well debated.
So why does the message create such controversy, and are we doing enough as educators to ensure that the complexity of the issues is communicated? Part of the problem may be the need to search for a scapegoat, but are we ensuring that investors fully understand issues such as the paradox of the market, or why some markets are efficient and others are not?
Textbooks in accounting and finance tend to have simplistic discussions of the topic, with the evidence concentrating on the U.S. stock market. It is relatively easy to understand the concept but much harder to appreciate the complexity of the issue. Have we let loose a generation of undergraduates who are inadequately trained, and who end up either treating the EMH as a piece of magic or simply rejecting the whole concept without the ability to explain why?
Consider those who accept market efficiency on faith. While they may be price-protected in a well-traded market, they will be more exposed in illiquid markets and out of their depth in a market where price setters can exist.
Perhaps the more dangerous groups are those who do not understand why markets can be difficult to beat and are ill-informed about the evidence and counter-evidence. Fox concludes that “while mindless conformism was characteristic of financial bubbles and panics long before there were finance professors, fostering even more of it has been the gravest sin of modern finance” (p. 328).
I think this book will challenge readers to better understand how some of the key developments in finance have evolved—the characters involved, the contradictions that occurred, and the maturing of thought, so that the difficult issues surrounding finance can continue to receive the attention that they deserve. Fox allows the characters to come alive, and he shows their willingness to be challenged by new ideas and evidence. Finance is not perfect, but Fox also makes sure that we know of the contribution that finance has made in better managing and pricing risk.
JAMES P. HAWLEY, SHYAM J. KAMATH, and ANDREW T. WILLIAMS (editors), Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis (Philadelphia, PA: University of Pennsylvania Press, 2011, ISBN 978-0-8122-4314-7, pp. vi, 344).
In the wake of the recent global financial crisis, the subject of financial risk and its relation to corporate governance has been widely debated among academics, practitioners, policymakers, and the business press. While most of the blame was targeted at corporate boards and executive compensation practices that rewarded extreme risk-taking behaviors, much less examined was the role of large, supposedly sophisticated, institutional investors. Institutional investors (which include pension funds, mutual funds, insurance companies, and, in some countries, banks) have dominated the global investment universe over the last two decades, becoming the majority owners of public equity and, more recently, other asset classes (e.g., hedge funds and private equity). In year 2009, for example, they owned more than 70 percent of the largest 1,000 U.S. companies compared to 45 percent owned at the end of the 1980s (The Conference Board 2010). During the same period, institutional investors have obtained increased ability to participate in (or have disclosure about) many discrete spheres of corporate governance in publicly held companies. In spite of their increased ownership and governance roles and the numerous warnings by, e.g., the OECD and the IMF, institutional investors failed to anticipate the crisis, with some commentators arguing that their inattentiveness to systemic risk played a crucial role for the crisis itself to occur.
Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis is a collection of essays, where researchers as well as legal and financial practitioners discuss the detrimental actions and inaction of institutional investors in the recent financial crisis. The book's contributors critique institutional investors for tolerating the “pursuit of alpha” culture (p. 3) that, often coupled with complex leverage instruments (e.g., credit default swaps), led fund managers to pursue too-risky strategies, without investigating the sustainability of their returns and their systemic risk effects. The volume also points out how institutional investors generally failed to effectively monitor their investee companies, ignoring relatively well-established governance principles (e.g., transparency and accountability) and best practices. Along with a detailed investigation of institutional investors' misdeeds, the book provides new perspectives on ways in which institutional investors can best act as risk and governance gatekeepers, promoting responsible investments, and restoring trust in capital markets.
The book consists of an introduction and ten chapters. Nine out of the ten chapters are revisions of presentations made at a conference titled ‘‘Institutional Investors, Risk/Return, and Corporate Governance Failures: Practical Lessons from the Global Financial Crisis,” which the three editors of the book hosted at Saint Mary's College of California in October 2009. The editors' introduction provides a good summary of the topics covered at the conference and in the book. The book focuses on the following main themes: What role did the paradigms from modern portfolio theory and the “pursuit of alpha” strategy play in the crisis? Can and should institutional investors effectively identify and monitor systemic risk? What was the role of other gatekeepers, such as governments, rating agencies, and financial intermediaries? Chapters 2–5 of the book focus on the first two questions. The remaining chapters investigate the role of institutional investors in relation with other key parties. Chapter 8 focuses on the crises in real estate markets. Finally, the last chapter focuses on aspects of socially responsible investing. Although the ordering of the chapters seems a little arbitrary (e.g., I would have envisioned Chapters 5 and 9 to be the first two chapters following the introduction), all chapters are well written and provide persuasive arguments, supported by examples and, in some cases, empirical analyses. The remainder of this review follows the structure of the book and describes the content of each chapter in more detail. A final section contains some concluding remarks.
Chapter 2 critically reviews the main principles of modern portfolio theory (MPT), and suggests that the theory fails to adequately acknowledge the extent to which investments at the portfolio level can affect the overall financial market. In particular, the techniques typically used to control “unsystemic” risk at the portfolio level (e.g., diversification, hedging, arbitrage, and leverage), while maximizing returns, can positively affect market risk when widely adopted. Alternative theories of investment are needed that encourage the assessment of the systemic effects of portfolio-level decisions. The chapter suggests that one such alternative definition derives from the observation that the different asset classes available to investors (i.e., cash, fixed-income securities, public equity, venture capital, commodities) can serve distinct financial and societal purposes. Under governments' guidance, these asset classes should create a mosaic of complementary investment opportunities that can help institutional investors in the pursuit of sustainable investment portfolios. Such a profound change in investment philosophy, strategy, and operations sounds, however, like a massive challenge.
In a similar vein, Chapter 3 also suggests that traditional financial models (such as MPT and CAPM) may well have contributed to the crisis, because they all fail to provide financial risk predictions under a stressed market scenario. The chapter provides a detailed roadmap to various types of financial risk (e.g., model risk, credit risk, operational risk, and business risk) and suggests that improved risk management practices within financial firms are a necessary (although not sufficient) element in preventing or minimizing future economic downturns. At the core of superior risk analyses is the ability to predict the relative contribution of a specific asset to the total market risk in a stressed market. The chapter also emphasizes the critical link between risk and governance, and illustrates its key points with case studies, such as Long Term Capital Management's failure. The chapter concludes that superior risk management and a deeper consideration of governance factors within financial firms should be encouraged by regulators in order to forecast and avoid other systemic losses.
Chapter 4 argues that the “pursuit of alpha” strategy was also a major factor in the corporate governance failures in the U.K. Underlying those failures were government policies that promoted London as a global financial, and relatively deregulated, center, enabling alpha's global pursuit. The U.K.'s financial services regulator was given a mandate to promote the City's financial competitiveness and, in order to achieve this, carried out its oversight through light-touch regulation and relaxed supervision. By 2007, London's share of the global over-the-counter derivatives and hedge fund assets exceeded 40 and 20 percent, respectively. When the world's banking system unraveled between 2007 and 2009, the U.K. was more exposed than most other countries. The chapter concludes that a regulatory and ideological orthodoxy rather than simpler governance oversights was the main explanation for the U.K. failures during the crisis.
Chapter 5, which was written by one of the book's editors, investigates institutional investors' general omissions in relation to the crisis. The chapter suggests that most institutional investors had missed a robust model of financial risk, and too few had developed alternative scenarios to the ones dominated by MPT. The chapter also suggests that a major disconnect between corporate governance and investment strategy existed, and that well-established governance standards (i.e., transparency, monitoring, and accountability) and portfolio risk analyses were not applied to the growing area of alternative investments (e.g., hedge funds and private equity), nor were they adequately applied to equity and debt investments in the financial sector itself (as in the case of Citigroup). The chapter concludes by suggesting that the future investment trends will need significant self-reflection by institutional investors on these failures.
Chapter 6 embraces the common view that executive incentives played a critical role in the crisis and investigates the often inconsistent efforts of institutional investors in enforcing “good” executive compensation practices in publicly listed companies. The chapter presents a model of the regulatory framework for executive pay that examines the role of institutional investors as the key gatekeepers within this framework. Institutional investors are now expected to have a greater involvement in the executive pay-setting process through the recently introduced “say on pay” provisions. The difficulty for institutional investors to be active monitors, however, relies on a general mismatch between the views on executive pay held by institutional investors and the general public. While the public usually sees executive pay as a quantum and distributive justice issue, institutional investors are generally less concerned about the quantum than about the performance outcomes of executive incentives. The chapter concludes that higher levels of government regulation would be required when such a mismatch would undermine the effectiveness of institutional investors' monitoring.
Chapter 7 investigates the role and limits of corporate law in relation to financial bubbles. Existing laws on governance, the chapter argues, are aimed at preventing managers from abusing the resources that investors have committed to companies, by requiring processes intended to detect and prevent misuse of those resources. The law does not, however, require managers to maximize corporate resources, nor make managers guarantors of financial results. As a consequence, those investors who lost billions in the 2007–2008 financial crisis and the citizens who saw public wealth used to bail out failed companies, would probably argue that the corporate processes were inadequate to protect their interests. Just two companies—American International Group (AIG) and Citigroup—accounted for approximately $800 billion of market capitalization losses and over $500 billion of government bailouts under the Troubled Asset Relief Program (TARP) program and additional government funds. This chapter considers—in the light of the AIG and Citigroup examples—the limits of corporate laws to generate adequate public protection during financial bubbles.
Chapter 8 analyzes the role of corporate governance in the real estate equity market. Although real estate was at the forefront of the financial crisis, the role of governance in the performance of real estate equity investments has received far less attention. Using data from U.S. real estate investment trusts (REITs), the chapter empirically tests the association between trust governance quality and equity returns in the two sub-periods before and during the crisis. While governance quality did not influence trust performance before the crisis, it became a key performance driver during and after the market downturn. One interpretation of these findings is that institutional investors did not adequately incorporate governance considerations into their decisions in the period prior to the crisis. This behavior is consistent with their investments in securitized debt products, where opacity of the investments was also heavily ignored.
Chapter 9 explores the legal and governance omissions that facilitated the collapse of the global financial system. These omissions enabled the boom and also made the bust mostly felt by the “ordinary” investors, while shielding many of the financial institutions that created the problems. Individuals were exposed to risky investments from which they would have been protected as direct, retail investors. Yet because “sophisticated” investors such as U.S. mutual funds and pension funds pooled their assets, they were exposed. These, often unregulated, assets were able to flourish by attracting more investments and were not restricted in the use of derivatives, leverage, and illiquid securities. This, coupled with investors' inability to monitor unregulated investment options, created the systemic risk at the basis of the crisis.
Chapter 10 examines the role of investment consultants in advising on institutional investors' capital allocation decisions. Using unique survey data from global investment consultants collected by the United Nations Environment Programme Finance Initiative (UNEPFI 2009), this chapter sheds light on the often conflicted position of investment consultants as both “thought leaders” with direct access to trustee board investment decisions and followers of clients' short-term demands. Developing a relational geographic model to situate investment consultants within the asset management chain, the chapter argues that most consultants have repeatedly failed to integrate environmental, social, and governance considerations into their mainstream valuation and advisory models. The chapter concludes that these cultural impediments, coupled with perverse short-term incentives, also contributed to creating those conditions for mispricing long-term assets that led to the crisis.
Chapter 11 examines the role of fiduciary law and pension funds with respect to climate risk. While financial and climate risk are not related as such, the chapter argues that they share some important attributes by current interpretations of fiduciary law. Reflecting on the context of the global financial crisis, the chapter argues that fiduciary duty should not be perceived as a barrier to pension funds' consideration of climate risk factors, and discusses the potential of pension funds to manage economic risk through climate risk analyses.
The book appeals to many different audiences. It is written in a way appropriate to inform researchers, financial professionals, and any other interested party with regard to the main forces underlying the recent financial crisis. Overall, the arguments presented in the book are comprehensive and tell an appealing story on institutional investors' responsibilities and offers nuanced proposals to prevent, or at least to minimize, the effects of another global financial crisis. It is a very good resource for researchers who want to develop their own understanding about financial risk and its relation to governance practices. Business executives and regulators will find this to be a well-written, accessible book that provides enough details without being overly technical. Although this book would be inappropriate as a primary text, it would be a good supplement for doctoral and M.B.A. advanced classes in financial accounting, public policy, and financial economics. Overall, I strongly recommend this book to anyone interested in developing an in-depth understanding of the most critical risk and governance issues surrounding the recent financial crisis.
For example see Paul Krugman, “School for Scoundrels,” The New York Times, August 6, 2009, accessed November 13, 2012 at: http://www.nytimes.com/2009/08/09/books/review/Krugman-t.html?pagewanted=all
Editor's note: Two copies of books for review should be sent to the Book Review Editor: Stephen A. Zeff, Rice University, Jesse H. Jones Graduate School of Business, 6100 Main St., Houston, TX 77005. The policy of The Accounting Review is to publish only those reviews solicited by the Book Review Editor. Unsolicited reviews will not be accepted.