JAMES Montier of Societe Generale features regularly in my column and blog, for which I make no apology; he writes consistently thoughtful strategy notes and has just been voted strategist of the year in the Extel polls. He has just given a speech at the UK's CFA conference on one of his bete noirs, efficient market theory.  He describes it as "the financial equivalent of Monty Python's Dead Parrot".

Coincidentally, Harper Business has just published The Myth of the Rational Market by Justin Fox (disclosure, many years ago, he was a near-neighbour), an intellectual tour-de-force in which he explains the development of financial economics over the 20th century. Together with Liaquat Ahamed's Lords of Finance, it is one of the two financial books I have enjoyed most this year.

Montier's point, echoed in the Fox book, is that efficient market theory depends on some simplifying assumptions that are simply not borne out in the real world. It assumes that rational traders will drive out the irrational, even though there are plenty of practical constraints (the difficulty in shorting, the ability to get access to finance in troubled markets) that may stop them from doing so. Long-Term Capital Management was "right" in assuming that the spread between risky and risk-free assets would narrow; it ran out of money before it could prove it.

But there are two strands to criticism of efficient market theory that need untangling. One is the assumption that market prices are always right.  From this developed the idea that bubbles cannot exist and thus that central banks should do nothing about rising asset prices. That belief may well have been dangerous. In particular, returns are not "normal", in the sense of following a bell curve distribution. They are plagued by fat tails or extreme outcomes; failing to allow for these outcomes contributed to the recent crisis. *

The second is the development of low-cost index funds. It is easy to assume that the argument for index funds depends on markets being efficient; it doesn't. The case for index funds simply depends on a truism; that the performance of the average investor must be based on the performance of the market before costs. Some managers will beat the market, but can we identify them in advance? If we cannot, then we are likely to pay 1-2% a year in expenses for nothing. And let us suppose we did have a way of reliably identifying the stars; then investors would give all their money to the stars and none to the underperformers. But some of the stars would have to fade; unlike the residents of Lake Wobegon, all investors cannot be "above average".

Markets aren't always rational but that is not the same as saying it is rational for the average investor to spend money trying to beat them.

* Allowing for fat tails makes the maths a lot more difficult. Indeed, it might mean that the trading arms of invetsment banks would take a lot less risk, no bad thing given recent events.