The paper was written in 2000 by Mark Rubinstein, a finance professor at University of California, Berkeley, and is entitled "Rational Markets: Yes or No. The Affirmative Case." It is Rubinstein's attempt to explain away all the evidence against the EMH, from excess volatility to anomalous predictable patterns in price movements and the existence of massive crashes such as the crash of 1987. I'm not going to get into too much detail, but will limit myself to three rather remarkable arguments put forth in the paper. They reveal, it seems to me, the mind of the true believer at work:
1. Rubinstein asserts that his thinking follows from what he calls The Prime Directive. This commitment is itself interesting:
When I went to financial economist training school, I was taught The Prime Directive. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had learned, enhanced with the new high-tech computers, databases and software, I would have to be careful how I used this power. Whatever else I would do, I should follow The Prime Directive:Rubinstein here is at least being very honest. He's going to jump through intellectual hoops to preserve his prior belief that people are rational, even though (as he readily admits elsewhere in the text) we know that people are not rational. Hence, he's going to approach reality by assuming something that is definitely not true and seeing what its consequences are. Only if all his effort and imagination fails to come up with a suitable scheme will he actually consider paying attention to the messy details of real human behaviour.
Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.
One has the feeling from the burgeoning behavioralist literature that it has lost all the constraints of this directive – that whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behavior.
What's amazing is that, having made this admission, he then goes on to criticize behavioural economists for having found out that human behaviour is indeed messy and complicated:
The behavioral cure may be worse than the disease. Here is a litany of cures drawn from the burgeoning and clearly undisciplined and unparsimonious behavioral literature:Now, there's sense in the idea that, for various reasons, individual behavioural patterns might not be reflected at the aggregate level. Rubinstein's further arguments on this point aren't very convincing, but at least it's a fair argument. What I find more remarkable is the a priori decision that an explanation based on rational behaviour is taken to be inherently superior to any other kind of explanation, even though we know that people are not empirically rational. Surely an explanation based on a realistic view of human behaviour is more convincing and more likely to be correct than one based on unrealistic assumptions (Milton Friedman's fantasies notwithstanding). Even if you could somehow show that market outcomes are what you would expect if people acted as if they were rational (a dubious proposition), I fail to see why that would be superior to an explanation which assumes that people act as if they were real human beings with realistic behavioural quirks, which they are.
Reference points and loss aversion (not necessarily inconsistent with rationality):
Endowment effect: what you start with matters
Status quo bias: more to lose than to gain by departing from current situation
House money effect: nouveau riche are not very risk averse
Overconfidence about the precision of private information
Biased self-attribution (perhaps leading to overconfidence)
Illusion of knowledge: overconfidence arising from being given partial information
Disposition effect: want to hold losers but sell winners
Illusion of control: unfounded belief of being able to influence events
Gambler’s fallacy: need to see patterns when in fact there are none
Very rare events assigned probabilities much too high or too low
Ellsberg Paradox: perceiving differences between risk and uncertainty
Extrapolation bias: failure to correct for regression to the mean and sample size
Excessive weight given to personal or antidotal experiences over large sample statistics
Overreaction: excessive weight placed on recent over historical evidence
Failure to adjust probabilities for hindsight and selection bias
Miscellaneous errors in reasoning:Violations of basic Savage axioms: sure-thing principle, dominance, transitivity
Sunk costs influence decisions
Preferences not independent of elicitation methods
Compartmentalization and mental accounting
“Magical” thinking: believing you can influence the outcome when you can’t
Dynamic inconsistency: negative discount rates, “debt aversion”
Tendency to gamble and take on unnecessary risks
Selective attention and herding (as evidenced by fads and fashions)
Anchoring and framing biases
Cognitive dissonance and minimizing regret (“confirmation trap”)
Disjunction effect: wait for information even if not important to decision
Tendency of experts to overweight the results of models and theories
Conjunction fallacy: probability of two co-occurring more probable than a single one
Many of these errors in human reasoning are no doubt systematic across individuals and time, just as behavioralists argue. But, for many reasons, as I shall argue, they are unlikely to aggregate up to affect market prices. It is too soon to fall back to what should be the last line of defense, market irrationality, to explain asset prices. With patience, the anomalies that appear puzzling today will either be shown to be empirical illusions or explained by further model generalization in the context of rationality.
But that's not how Rubinstein sees it. Explanations based on a commitment to taking real human behaviour into account, in his view, have "too much of a flavor of being concocted to explain ex-post observations – much like the medievalists used to suppose there were a different angel providing the motive power for each planet." The people making a commitment to realism in their theories, in other words, are like the medievalists adding epicycles to epicycles. The comparison would seem more plausibly applied to Rubinstein's own rational approach.
2. Rubinstein also relies on the wisdom of crowds idea, but doesn't at all consider the many paths by which a crowd's average assessment of something can go very much awry because individuals are often strongly influenced in their decisions and views by what they see others doing. We've known this going all the way back to the famous 1950s experiments of Solomon Asch on group conformity. Rubinstein pays no attention to that, and simply asserts that we can trust that the market will aggregate information effectively and get at the truth, because this is what group behaviour does in lots of cases:
The securities market is not the only example for which the aggregation of information across different individuals leads to the truth. At 3:15 p.m. on May 27, 1968, the submarine USS Scorpion was officially declared missing with all 99 men aboard. She was somewhere within a 20-mile-wide circle in the Atlantic, far below implosion depth. Five months later, after extensive search efforts, her location within that circle was still undetermined. John Craven, the Navy’s top deep-water scientist, had all but given up. As a last gasp, he asked a group of submarine and salvage experts to bet on the probabilities of different scenarios that could have occurred. Averaging their responses, he pinpointed the exact location (within 220 yards) where the missing sub was found.
Now I don't doubt the veracity of this account or that crowds, when people make decisions independently and have no biases in their decisions, can be a source of wisdom. But it's hardly fair to cite one example where the wisdom of the crowd worked out, without acknowledging the at least equally numerous examples where crowd behaviour leads to very poor outcomes. It's highly ironic that Rubinstein wrote this paper just as the dot.com bubble was collapsing. How could the rational markets have made such mistaken valuations of Internet companies? It's clear that many people judge values at least in part by looking to see how others were valuing them, and when that happens you can forget the wisdom of the crowds.
Obviously I can't fault Rubinstein for not citing these experiments from earlier this year which illustrate just how fragile the conditions are under which crowds make collectively wise decisions, but such experiments only document more carefully what has been obvious for decades. You can't appeal to the wisdom of crowds to proclaim the wisdom of markets without also acknowledging the frequent stupidity of crowds and hence the associated stupidity of markets.
3. Just one further point. I've pointed out before that defenders of the EMH in their arguments often switch between two meanings of the idea. One is that the markets are unpredictable and hard to beat, the other is that markets do a good job of valuing assets and therefore lead to efficient resource allocations. The trick often employed is to present evidence for the first meaning -- markets are hard to predict -- and then take this in support of the second meaning, that markets do a great job valuing assets. Rubinstein follows this pattern as well, although in a slightly modified way. At the outset, he begins making various definitions of the "rational market":
This, he readily admits, isn't true:I will say markets are maximally rational if all investors are rational.
Although most academic models in finance are based on this assumption, I don’t think financial economists really take it seriously. Indeed, they need only talk to their spouses or to their brokers.But he then offers a weaker version:
... what is in contention is whether or not markets are simply rational, that is, asset prices are set as if all investors are rational.In such a market, investors may not be rational, they may trade too much or fail to diversify properly, but still the market overall may reflect fairly rational behaviour:
In these cases, I would like to say that although markets are not perfectly rational, they are at least minimally rational: although prices are not set as if all investors are rational, there are still no abnormal profit opportunities for the investors that are rational.This is the version of "rational markets" he then tries to defend throughout the paper. Note what has happened: the definition of the rational market has now been weakened to only say that markets move unpredictably and give no easy way to make a profit. This really has nothing whatsoever to do with the market being rational, and the definition would be improved if the word "rational" were removed entirely. But I suppose readers would wonder why he was bothering if he said "I'm going to defend the hypothesis that markets are very hard to predict and hard to beat" -- does anyone not believe that? Indeed, this idea of a "minimally rational" market is equally consistent with a "maximally irrational" market. If investors simply flipped coins to make their decisions, then there would also be no easy profit opportunities, as you'd have a truly random market.
Why not just say "the markets are hard to predict" hypothesis? The reason, I suspect, is that this idea isn't very surprising and, more importantly, doesn't imply anything about markets being good or accurate or efficient. And that's really what EMH people want to conclude -- leave the markets alone because they are wonderful information processors and allocate resources efficiently. Trouble is, you can't conclude that just from the fact that markets are hard to beat. Trying to do so with various redefinitions of the hypothesis is like trying to prove that 2 = 1. Watching the effort, to quote physicist John Bell in another context, "...is like watching a snake trying to eat itself from the tail. It becomes embarrassing for the spectator long before it becomes painful for the snake."