NOAH SMITH: When rational market theory meets irrational human beings
'Typically, no one knows which trades are placed by the rational folks, and which are by misinformed speculators'
To many young people, the idea of efficient financial markets -- the idea that, in the words of economist Eugene Fama, “At any point in time, the actual price of a security will be a good estimate of its intrinsic value” - probably seems like a joke. The financial crisis of 2008, the bursting of the housing bubble, and gyrations in markets from gold to Bitcoin to Chinese stocks have put paid, at least for now, to the idea that prices are guided by the steady hand of rationality. The theory won Fama an economics Nobel Prize in 2013, but he shared it with Robert Shiller, whose research poked significant holes in the idea decades ago. But believe it or not, there was a time when efficient markets theory occupied a place of honor in the worldview of economists and financial professionals alike. This is chronicled in my colleague Justin Fox’s excellent book, “The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.” Though Fama did empirical research that ...
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