Why Adaptive Markets Theory Provides A New Paradigm in Finance
Can a Behavioural Theory on Markets Replace Efficient Market Hypothesis?
SF: Andrew Lo is a professor of finance, and the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management. He is the author of numerous articles in finance and economics journals, and has most recently published Adaptive Markets: Financial Evolution at the Speed of Thought. In his book, Lo argues that Efficient Markets Theory does not provide a complete understanding of markets. He talks to Professional Investor about why his own theory of adaptive markets, driven by how individuals make decisions, addresses some of the gaps.
PI: Why Adaptive Markets?
Lo: This book was due to come out in April 2008, and it was a real process for me, because I started out, as with many of my colleagues, as an efficient markets disciple. I worked with the data, and then I looked at all sorts of violations of efficient markets, and tried to make sense of them. This book was a journey towards that process. Then the financial crisis hit and I started trying to understand that series of events, because traditional paradigms weren’t relevant anymore. Throughout that process, I was able to sharpen some of my ideas, and this book was the result.
PI: You talk about the fact that Efficient Markets is not a complete theory. And yet, it is still widely used, particularly in academia, but also in practical finance. Do we need to change mind-sets?
Lo: I do think we need to change the mind-sets of the profession, and that’s not an easy thing to do. From an academic perspective, many of my colleagues already understand that efficient markets is not a complete theory, and that we need to deal with human behaviours in a systemic way.
PI: What practical considerations can investors take away from your approach?
Lo: There’s a complex ecosystem that characterises financial markets, and that ecosystem is highly competitive. So you need to innovate, and you need to understand who the predators and who the prey is, in order to navigate the system. Human behaviour has not changed a lot over the last 60,000 years. We are still the same creatures we were in the Neolithic Ice Age. When we are faced with extreme losses we will freak out and start making decisions that are not rational, but instinctive. So the implications for portfolio managers is to know thyself, and know your clients to really understand how human behaviour interacts with what you do.
PI: But how easy will it be for practitioners to create models based on Adaptive Markets?
Lo: It will be harder. I’m proposing to change the way we think about markets from a physical system that has immutable laws the way that Isaac Newton envisioned the physical world, to a more complicated interconnected ecology, the way that Charles Darwin envisioned. There are mathematical relationships in the world of evolutionary biology, but it doesn’t have the same predictive power.
PI: You’ve talked about the era of Big Data and how it might actually speed some of this process, and of a ‘quant psych’ revolution, albeit years from now?
Lo: One of the bi products of big data and of artificial intelligence is the ability to identify patterns in large swathes of consumer behaviour. I have a terrible habit of purchasing books online from Amazon, and then purchasing more when Amazon says ‘people who bought this book also bought this other book’. It’s a devious feature that is incredibly simple from a software perspective, but it is a very sophisticated way of using data to target my personal preferences. Imagine a world where we have investors who are engaging in various different kinds of investment decisions – for example when you make a decision to purchase Apple stock – and you get an alert that investors like you have also purchased these other stocks. That presents both opportunities, but also challenges. Adaptive markets theory is probably the only thing that will allow us to break free from the current cycle we are now in, that develops financial products that don’t fit the consumer. Technology will help us quantify that human behaviour.
PI: Any final message for investors?
Lo: The message I would like to leave investors with is that efficient markets hypothesis is not wrong. My book is not meant to be a critique of that, and that’s important, because I don’t want financial advisors to think that everything they have learnt is not important. It is an important powerful theory but it is not a complete theory.
Andrew Lo’s Eminent Speaker presentation to members of CFA UK is now available to view from our Knowledge Centre. You can access the recording by using the following link: Adaptive Markets - Andrew Lo