Justin Fox's The Myth of the Rational Market reviews the development of financial economics, starting from Irving Fisher, with his The Theory of Interest, to Robert Shiller, with his study in behavioral finance, challenging the efficient-market hypothesis.
The main focus in the study of rational market is, in which way we could recognize those investing behavior?
For rational market theory, the best-known element is the efficient-market hypothesis, formulated at the University of Chicago in the 1960s with reference to the U.S stock market. The behavior of average investor is the market, which means those investors can't beat the market. Most of those investors dreamed that they could win, more or less, from the market. They don't know they're the part of it, determining by another form of "invisible hand".
In 1938, when he published the results of his long NBER research project on financial markets in book form, Macaulay explained why. “If the vagaries of individual conduct were always ‘normally’ distributed round a strictly rational ‘mode,’” he wrote, “their curbing effects on the development of economics as a strictly logical social science might be small or negligible.” The errors made by investors and speculators betting on the future via financial markets weren’t random, though. They were “systematic” and “constant,” the inevitable result of the “emotion, lack of logic and insufficiency of knowledge” that characterized all human decision making but especially decision making about the future.
Although every investor has his own "strategy" on investing portfolio, the whole market is hardly becoming "random". It looks like "random", but we give a name on that "random walk". The phrase “random walk” appears to have been coined in 1905, in an exchange in the letters pages of the English journal Nature concerning the mathematical description of the meanderings of a hypothetical drunkard. In 1963, Morgenstern and Granger published a paper confirming that, according to their tests, stock prices moved in a short-term random walk (over the longer run, the movements didn’t look quite so random).
Eugene Fama, the father of of the efficient-market hypothesis, digs more on intrinsic value. “In an efficient market,” he wrote, “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value.” His “superior intrinsic-value analysis” illustrates that in a dynamic economy there will always be new information which causes intrinsic values to change over time. As a result, people who can consistently predict the appearance of new information and evaluate its effects on intrinsic values will usually make larger profits than can people who do not have this talent. For those investors, if you cannot consistently predict new-coming information and evaluate its effects, you are mostly out of high profits club, or you are on the edge of this game.
Some people still wonder they could grieve something from the past, the historical move, or illegally from inside trade, but the efficient-market hypothesis tells you another truth. “Weak” efficiency was the old random walk hypothesis: You couldn’t expect to beat the market using data on the market’s past movements. “Semi-strong” efficiency meant that you couldn’t beat it using any publicly available information. And “strong” efficiency described a market so perfect that even investors with access to private information couldn’t outsmart it.
I do believe you life ends with the so-called "strong" efficiency. It's done.
However, Warren Buffett and Ed Thorp tell you another story for hopeless investors. The difference between the worldview of Buffett and Thorp and that of rational market finance was chiefly one of time frame. The finance guys thought markets got things right immediately. The moneymen believed it could take a while. MRI experiments conducted by psychologists and behavioral economists showed that the more advanced, uniquely human parts of the brain are most active when we choose for the long run, while more primitive sections are in charge when we choose gratification now.
Here's one example. By the early 1980s, several headhunting firms already specialized in luring disgruntled physicists, mathematicians, and engineers to Wall Street jobs. Many of these quants manufactured new derivatives or managed risk. Of the ones enlisted to beat the market, most were involved in Thorp-style arbitrage—finding two securities that seemed mispriced relative to each other, then using lots of borrowed money to bet the prices would move back in line. Others followed Barr Rosenberg’s path into value investing—using a computer to locate hundreds of cheap stocks rather than the conventional handful. Ever-more-powerful computers also allowed money managers to troll through ever-more-plentiful price data in search of identifiable patterns and trends—a practice that was, by the end of the decade, beginning to gain academic respectability. Some quantitative managers mixed elements of all three approaches.
In a speech that would become famous, Greenspan asked, “How do we know when irrational exuberance has unduly escalated asset values?”
As Thaler said, “Because human nature is a mess…It’s a choice between being precisely wrong or vaguely right.” Then we develop behavioral finance, trying to catch those "moment" in the market.
It's hard to tell whether the efficient-market hypothesis works in the real rational market, but just because market prices sometimes got way out of line with fundamentals didn’t mean it was easy to make money off that knowledge.
We have watched irrational exuberance and disaster on stock market in China for the latest 20 years. It is a highly volatile market, with notorious history, including the split-share structure reform for "untraded shares", mysterious timing for CSRC to review the application documents, and almost "fixed" earning for stagging. It is far away for capital to move free, and even far away for rational analyst to judge the intrinsic value of a simple stock. People looks speculative, and play like gambler. When the index goes up, the market lures new-comers for valuable payoff. But with bear market, your money is sunk. For me, I still cannot find a simple reason for investing in such kind of market.