Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. LoAdaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Adaptive Markets: Financial Evolution at the Speed of Thought

byAndrew W. Lo

Hardcover | May 2, 2017

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A new, evolutionary explanation of markets and investor behavior

Half of all Americans have money in the stock market, yet economists can't agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe-and as financial bubbles, crashes, and crises suggest. This is one of the biggest debates in economics and the value or futility of investment management and financial regulation hang on the outcome. In this groundbreaking book, Andrew Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist.

Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, Adaptive Markets shows that the theory of market efficiency isn't wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit. Lo's new paradigm explains how financial evolution shapes behavior and markets at the speed of thought-a fact revealed by swings between stability and crisis, profit and loss, and innovation and regulation.

A fascinating intellectual journey filled with compelling stories, Adaptive Markets starts with the origins of market efficiency and its failures, turns to the foundations of investor behavior, and concludes with practical implications-including how hedge funds have become the Galápagos Islands of finance, what really happened in the 2008 meltdown, and how we might avoid future crises.

An ambitious new answer to fundamental questions in economics, Adaptive Markets is essential reading for anyone who wants to know how markets really work.

Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. He is the author of Hedge Funds and the coauthor of A Non-Random Walk Down Wall Street and The Econometrics of Financial Markets (all Princeton). He is also the founder of Alp...
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Title:Adaptive Markets: Financial Evolution at the Speed of ThoughtFormat:HardcoverDimensions:504 pagesPublished:May 2, 2017Publisher:Princeton University PressLanguage:English

The following ISBNs are associated with this title:

ISBN - 10:0691135142

ISBN - 13:9780691135144

Reviews

Rated 5 out of 5 by from Lo and Behold: A Thoughtful View on the Evolution of Markets Andre Lo, professor of finance and director of the Laboratory for Financial Engineering at MIT, has spent his career measuring, analyzing and theorizing about financial assets (stocks, derivatives, funds) and financial markets. Among his many publications is a 2005 paper entitled “The Adaptive Markets Hypothesis”, which sought to integrate traditional and behavioral finance. More than a decade later, Lo has expanded his academic effort into an excellent book aimed broadly at enquiring minds. Well written and with clear explanations of many complex financial theories (traditional and behavioral), the book is a thought-provoking look into the future. Two chapters (1 and 6), in particular are worth the price of admission alone: Lo’s summary of the efficient market hypothesis (EMH) and its relationship to behavioral finance; and his demonstration of biological economics and population robustness as the root of our financial behavioral biases. As an accomplished researcher himself, Lo cites much of his earlier work. For example, his 2009 empirical work on stop-loss selling would have produced since 1929 almost 1% of alpha (outperformance) annually, and with less volatility over a buy and hold strategy. Lo goes on to highlight other dynamic index possibilities (the best known of which are the target date maturity ones that rebalance every five years or so to match an investor’s age and time horizon). Lo’s theory isn’t so much a replacement for EMH, but rather a complement to it. It sits overtop and tries to explain the areas in which EMH and modern portfolio theory are deficient – the behavioral aspects of finance. Suggesting a growing need for his theory, Lo states “the relevant question isn’t whether [EMH] assumptions are literally true—few economic assumptions are—but rather, whether the approximation errors associated with them are small enough to ignore for practical purposes. The emerging narrative from the perspective of the Adaptive Markets Hypothesis is that these errors used to be small, but have grown considerably in recent years.” Despite the historical empiricism though, Lo minimizes the difficulty of identifying in advance what is mispriced and can be exploited. He notes other market imperfections, and offers ways they too might be exploited … for a while, acknowledging they would likely become quickly incorporated into standard financial practice and drop to market performance. In many respects, Lo’s Adaptive Markets Hypothesis is no different than traditional fundamental stock analysis – a tough, never ending quest for cost-effective ways to identify mispriced securities and markets. At least when it was current, Fama and French’s three factor model included identifiable targets (smaller companies and value stocks). From a more macro perspective, Lo’s new theory also challenges the work of Hyman Minsky. For example, in applying his behavioral hypothesis to the regulation of financial institutions, Lo implicitly aims for smoother markets (and who doesn’t want to prevent future crashes), but as Minsky explains in Stabilizing an Unstable Economy, the very act of stabilization eventually causes crashes: stability breeds instability. Lo assumes that experts will not only be able to identify bubbles or behavioral trends but will be able to profit from that identification. (Even the consummate insider, Alan Greenspan’s comment about the market’s ‘irrational exuberance’ was three years early in 1996!). Demonstrating the pervasiveness of our unpredictable behavioral outcomes, Lo includes a wonderful anecdote about how an erroneous opinion by an expert came to be conventional regulatory wisdom, and which inevitably led to poor policy prescriptions. In light of this, his recommendation for smarter regulation and deeper understanding of complex financial systems seems optimistic. If only we could be more rational, we could both build a more robust system and profit from others’ irrationality. Alas, even adaptive markets seem somewhat doomed to adjust by (painful) trial and (costly) error. Notwithstanding his well referenced hypothesis, the practicality of combining the best of low-cost diversified investing and market prediction into Lo’s proposed dynamic financial indices will limited. For individual investors, the same heuristics that produce the market imperfections will be the same ones they use in choosing their dynamic indices. Lo does partially acknowledge the challenge for professional investors, recognizing that they will need to shift their approaches dynamically. As with more traditional investment strategies, winning approaches are adopted by other market participants and profitable opportunities competed away – or in finance jargon, alpha becomes beta. Lo’s work may be more a complement to EMH than a foundational hypothesis, but his book is still a thought provoking synthesis of both traditional and behavioral finance, and from a much different perspective than the behavioral work of Thaler, Statman, and Shiller. It should be read by all with an interest in the limitations of traditional theories and in exploring leading edge financial thought.
Date published: 2017-12-11

Table of Contents

Introduction 1

Financial Fear Factor 1

Don't Try This At Home 4

The Great Divide 6

"It's the environment, stupid!" 8

Revenge of the Nerds 10

1 Are We All Homo economicus Now? 12

Tragedy and the Wisdom of Crowds 12

A Random Walk through History 16

The Birth of Efficient Markets 20

Efficient Markets Unpacked 25

What to Expect When You're Expecting 28

Efficient Markets in Action 38

2 If You're So Smart, Why Aren't You Rich? 45

Rejecting the Random Walk 45

Risk versus Uncertainty and the Ellsberg Paradox 51

Losing Hurts More than Winning Feels Good 56

No-Limit Texas Hold 'em, Rogue Traders, and Regulators 59

Probability Matching and March Madness 62

Humans as Prediction Machines 65

It Takes a Theory to Beat a Theory 69

Culture Shock 71

3 If You're So Rich, Why Aren't You Smart? 75

Looking under the Hood 75

The Microscope of Neuroscience 76

Fear 78

Pain 85

Pleasure and Greed 87

Wired-Up Traders 92

The Stuff Good Traders Are Made Of 94

Mind over Money via Neural Currency 96

I Want It All, and I Want It Now 98

4 The Power of Narrative 102

A New Meaning of Rationality 102

The Human Fire Alarm and Sprinkler System 104

The Fear Factor and Finance 106

I Know You Know That I Know 108

Homo economicus and the Left Hemisphere 113

The Prefrontal Cortex as CEO 117

The Power of Self-Fulfilling Prophecies 123

Barbara Ficalora, the Best Third Grade Teacher Ever 124

Narrative Is Intelligence 128

5 The Evolution Revolution 135

A Day at the Zoo 135

The Evolution Revolution 136

Just-So Stories or Scientific Fact? 138

The Power of Selection 141

Variety Is the Spice of Life 144

"It's the environment, stupid!" 146

The Emergence of Homo sapiens 150

Enter Homo economicus 152

An Evolutionary Pecking Order 156

Swedish Twins and Savings 158

Evolution at the Speed of Thought 162

Sociobiology and Evolutionary Psychology 168

Survival of the Richest? 175

6 The Adaptive Markets Hypothesis 176

It Takes a Theory to Beat a Theory 176

Simon Says Satisfice 177

The Superman Jacket 182

The Adaptive Markets Hypothesis 185

Probability Matching Explained 189

Nature Abhors an Undiversified Bet 195

"It's the environment, stupid!" All Over Again 196

Homo economicus and Idiosyncratic Risk 198

The Origin of Risk Aversion 203

Efficient versus Adaptive Markets 206

Waylaid by Physics Envy 208

On the Shoulders of Giants 214

7 The Galapagos Islands of Finance 222

Quantum Mechanics 222

Mission Impossible 224

The Islands of Evolution 225

Hedge Fund Archipelago 227

An Evolutionary History of the Hedge Fund 231

The Birth of Quants 235

The Revenge of the Nerds 236

Quant Goes Mainstream 240

The Evolution of the Random Walk 244

Cell Phones and Kerala Fishermen 246

8 Adaptive Markets in Action 249

The Traditional Investment Paradigm 249

The Great Modulation 254

A New World Order 256

Risk/Reward and Punishment 258

The Democratization of Investing 263

New Species of Index Funds 265

Smart Beta versus Dumb Sigma 267

Disbanding the Alpha Beta Sigma Fraternity 271

The Random Walk Revisited 277

A New Investment Paradigm 282

The Quant Meltdown of August 2007 283

Forensic Finance 284

Adaptive Markets and Liquidity Spirals 289

1998 versus 2007 292

9 Fear, Greed, and Financial Crisis 296

Ecosystem Ecology 296

Financial Crisis 101 298

Clear as Rashomon 301

Not Enough Skin in the Game? 303

Regulators Asleep at the Wheel? 306

Red Pill or Blue Pill? 312

Could We Have Avoided the Crisis? 314

The Adaptive Markets Hypothesis Explains 318

(Ab)Normal Accidents 320

Liquidity Withdrawal Symptoms 324

10 Finance Behaving Badly 330

Finance Rules 330

Out-Ponzi-ing Ponzi 332

The Ultimatum Game 335

A Neuroscience of Morality? 338

Is Finance Fair? 340

Finance and the Gordon Gekko Effect 345

Regulatory Culture 349

Environment Strikes Again 352

Moore's Law versus Murphy's Law 355

The Tyranny of Complexity 361

11 Fixing Finance 365

An Ounce of Prevention 365

Ecosystem Management 366

Adaptive Regulation 368

Law Is Code 371

Mapping Financial Networks 375

The CSI of Crises 378

Privacy with Transparency 384

Anti-Gekko Therapies 387

12 To Boldly Go Where No Financier

Has Gone Before 395

Star Trek Finance 395

"Computer, manage my portfolio!" 397

Curing Cancer 400

Eliminating Poverty 411

A New Narrative 415

I Want To Be Harvey Lodish 418

Notes 421

References 439

Acknowledgments 463

Index 469

Editorial Reviews

"This is a wonderful book. Andrew Lo traces a journey in which he reconsiders rationality in economics, moving from the efficient market hypothesis to his own Adaptive Markets Hypothesis through psychology, neuroscience, biology, and studies of financial innovations and crises. The book presents many valuable findings and is also full of emotion-enthusiasm, joy, frustration, and pain. It is itself a manifestation of the important finding that rational thinking and emotion go together."-Nobuhiro Kiyotaki, Princeton University