Rational Markets: Yes or No? The Affirmative Case

Abstract:     
With the recent flurry of articles declaiming the death of the rational markets hypothesis, it is well to pause and recall the very sound reasons this hypothesis was once so widely accepted at least in academic circles. Although academic models often assume that all investors are rational, this is clearly an expository device not to be taken seriously. However, what is in contention is whether markets are "rational" in the sense that prices are set as if all investors are rational. Even if markets are not rational in this sense, there may still not be abnormal profits opportunities. In that case, we say the markets are "minimally rational". This article maintains that developed financial markets are minimally rational and, with two qualifications, even achieve the higher standard of rationality.

In particular, it contends that realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. It also argues that investor irrationality, to the extent it affects prices, is particularly likely to be manifest through overconfidence, which in turn is likely to make the market in an important sense hyper-rational. To illustrate, the paper ends by re-examining some of the most serious evidence against market rationality: excess volatility, the risk premium puzzle, the size anomaly, closed-end fund discounts, calendar effects and the 1987 stock market crash.

Working Paper Series