The Madness of Mobs or The Wisdom of Crowds?...

For most of the last 50 years, economists have supported the idea that markets are “efficient” and that securities prices fully reflect all available information. This theory about how markets function (the Efficient Market Hypothesis or EMH) is based on a set of laws that describe how investors behave (they are rational and profit maximizing) and prices adjust. The problem, however, is that we have long known that investors do not always behave in a rational manner. The EMH does little, for example, to explain the 23% decline in stock prices on October 19, 1987 or the 2008-2009 stock market collapse.

More recently, the field of Behavioral Finance has attempted to better describe investor behavior. While this work has produced some important insights, it has failed to come up with a comprehensive theory of market behavior that could replace the EMH. Andrew Lo’s latest book, Adaptive Markets, offers a very credible alternative to the existing EMH.

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Lo developed his Adaptive Markets Hypothesis (AMH) over the course of the last 28 years while teaching Finance at MIT’s Sloan School of Management. His research draws heavily on a number of fields including psychology, evolutionary biology and artificial intelligence and his book provides a crash course on each. At its core, the AMH holds that markets do not follow a set of immutable laws like physics. Biological concepts such as competition, innovation and adaptation better describe market behavior. Investors are not always rational but rather use emotion to select advantageous and disadvantageous behaviors. Our deep-seated need for narratives and heuristics (rules of thumb) help us manage large amounts of incoming data and make predictions about the future. But they can also get us into trouble when we fail to see the whole story.

The Adaptive part of his title is important. According to Lo, financial markets and their participants evolve in much the same way that species adapt to their changing environments. But rather than physical adaptation, this evolutionary process can be applied to a generation of new ideas. The problem, however, is that our “evolution of ideas” is not always fast enough to keep up with the rapid changes in financial markets. Our hard-wired behavioral biases and inability to “keep up” with change lie behind the sometime irrational market behavior. This is particularly true today when technological change has increased both the speed and complexity of market forces.

Under Lo’s view of the world, risk may not always be sufficiently compensated by return, and securities prices may, because of strong emotional responses like fear and greed, deviate from rational levels. Further, Lo’s theory implies an ongoing process of market adjustment and adaptation to the changing economic and business environment. The hedge fund industry’s continuous attempt to find the next best “mousetrap” is a real life example of Wall Street species adaptation.

Lo’s research includes studies on actual investor behavior and detailed analysis of a number of recent stock market crashes. He is also the founder of an investment management company whose strategies employ ideas spelled out in his AMH. He has specific ideas about how his theory can be applied in product development (portfolios that dynamically adjust risk levels) and public policy. He is a firm believer that financial markets can be used as powerful tools to aggregate information quickly and cheaply and that, with sufficient political will, this information can be used to help solve a number of major societal problems including cancer and poverty.

While this book may appear best suited to those with a deep interest in finance, it is actually an easy read full of wonderful stories about how ideas from a range of disciplines combine to create new insights. Like all successful evolutionary processes, Lo’s work takes the best of the existing (EMH) paradigm and builds on it to better reflect markets as they exist today. This is adaptation at its best.