Rational Markets: Yes or No? The Affirmative Case

Abstract

With the recent flurry of articles declaiming the death of the rational market 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 assumption is clearly an expository device not to be taken seriously. 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, abnormal profit opportunities still may not exist. In that case, markets may be said to be "minimally rational"; I maintain that not only are developed financial markets minimally rational, they are, with two qualifications, rational. I contend 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. I also argue that investor irrationality, to the extent that it affects prices, is particularly likely to be manifest through overconfidence, which in turn, is likely to make the market hyper-rational. To illustrate, the article reexamines some of the most serious historical evidence against market rationality.