Credit crunch causes analysts to rethink rational market theory

By Gillian Tett, Capital Markets Editor
Published: June 16 2009 03:00 Financial Times

A new realisation has dawned among the most fervent advocates of financial analysis and collective investor wisdom: markets are not always rational.

For the past five decades, the Chartered Financial Analyst Institute has been teaching the tenets of analysis based on efficient markets to tens of thousands of adherents from banks, fund managers and investment houses that make up the global financial system.

Now, however, the credit crisis has forced high priests of rational market theory to question their own creed.

The British CFA recently asked members for the first time whether they trusted in "market efficiency" - and discovered more than two-thirds of respon-dents no longer believed market prices reflect all available information. More startling, 77 per cent of the group "strongly" or "very strongly" disagreed that investors behaved "rationally" - in apparent defiance of the "wisdom of crowds" idea that has driven investment theory.

The shift is significant as the assumption of efficient markets is a cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation.

William Goodhart, chief executive of the CFA Society of the UK, yesterday admitted the results showed a new mood of "questioning" following the financial crisis.

However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called "efficient markets" hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.

Extremities of recent market swings have sparked interest among politicians and investors in the field of behavioural finance, which asserts that markets do not behave rationally but can be driven by human emotions such as fear.

However, the CFA survey suggests the finance industry is not yet ready to rip up its creed.