Markets can be wrong

Posted on / Comment / Opinion - Markets can be wrong and the price is not always right.

Richard Thaler in the FT:

I recently had the pleasure of reading Justin Fox’s new book The Myth of the Rational Market . The book was mostly written before the financial crisis . However, it is natural to ask if the experiences over the last year should change our view of the EMH.

It helps to start with a quick review of rational finance. Modern finance began in the 1950s when many of the great economists of the second half of the 20th century began their careers. The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.

And amazinglty most economists are still doing just that. Taking the easy bits, applying their neat little formulas and saying the world's just fine, when it's very, very broke.

Three things economists really have to learn:

a) inadequate maths proves nothing

b) the absence of data is not the absence of evidence of a problem

c) Finding statistical signifcance in a correlation is not the same as finding significance, let alone cause.

But this has not occurred to the vast majority of them.

No wonder we're in a mess.