Review: 'Myth of the Rational Market' shows stock foibles

— -- Can you pick stocks that beat the market? Can anyone? Yes, but it's nearly impossible. That's the conclusion drawn by Justin Fox in The Myth of the Rational Market after spending years tracing the evolution (and eventual discrediting) of the Efficient Market Hypothesis.

Formulated by University of Chicago finance professor Eugene Fama in the 1960s, the hypothesis says stock prices are random, can't be predicted based on past movements or publicly available information and are, in some fundamental sense, right.

This hypothesis — which Fox calls the Rational Market Theory — is more than just an academic exercise. Among other things, it led to the invention of index mutual funds, now worth $604 billion and owned by 13% of U.S. households. Unlike actively managed funds run by pros who decide what to purchase and when to sell, index funds own baskets of stocks or bonds replicating indexes such as the Standard & Poor's 500.

According to the Efficient Market Hypothesis, there's no point in paying a pro to beat the market when you can buy the market itself.

But Fox, Time magazine business and economics consultant, maintains that the efficient market theory also helped create the current economic chaos. By his reckoning, trust in financial markets explained the laissez-faire attitude taken by the government toward derivatives and the housing bubble.

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Fox spends more than 300 yawn-inducing pages slogging through the rise and eventual fall of the Rational Market Theory (his 2002 Fortune article inspiring the book was far more interesting). Finally, he offers two lessons:

•It is hard to beat the market. Assume the market is smarter than you. But if you come up with an idea for beating it, "you need a model that explains why everybody else isn't already doing the same thing," says Fox.

•The chances of beating the market are even harder if you hire a fund manager. His fee cuts into the fund's returns. And the fund's past performance is no guarantee of future results.