Scan barcode
A review by wilte
Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo
4.0
I had very high expectations that were not completely fulfilled. The book feels a bit unorganised and a rambling collection of cool insights.
It also takes a while to get to the main point (the Adaptive Markets Hypothesis in Chapter 6, almost half way in the book). In the chapters before that we get an introduction to (behavioral) economics, and to the theory of evolution. Perhaps because of my background (evolutionary biologist working at a financial regulator), I did not read a lot of new things. Obviously financial markets and evolutionary theory are related...
Plenty of interesting stuff, though, and probably a good starter. Beinhocker's The Origin of Wealth: Evolution, Complexity, And the Radical Remaking of Economics (2006) is probably more in depth (but it is a while since I read that book, plus the financial world has been on a roler coaster since that book was published).
The Adaptive Markets Hypothesis is based on insight that financial markets behave more like biology than physics (p2). The Efficient Markets Hypothesis is not wrong, it is incomplete (p3). The wisdom of the crowds is sometimes overwhelmed by the madness of mobs. Lo introduces it, because it takes a theory to beat a theory. Incidently, John Boggle has the Costs Matter Hypothesis (p265).
p262: Under the AMH, risk isn't necessarily always rewarded, it depends on the environment.
p188:
However, even evolution at the speed of thought hasn't completely adapted to trading at the speed of light (p360).
Financial behavior that may seem irrational now is really behavior that hasn't had sufficient time to adapt to modern contexts (p9).
p189 (parafrased): Supotimal behavior is going to happen when we take heuristics (rules of thumb) out of the environment in which they emerged (evolved). Not "irrational" but "maladaptive".
Many behavioral biases are the result of our natural human tendency to forecast and plan ahead - but applied to the wrong environment (p66) We are short term demanding and long-term inattentive by nature (p99).
p103 Damasio: to be fully rational, we need emotion. When ability to experience emotions is removed, human behavior becomes less rational (p108; from Damasio (1994) Descartes' Error: Emotion, Reason and the Human Brain).
p117: Human is not a rational animal, but a rationalizing animal (Gazzaniga work).
EMH: Prices fully reflect all available information, markets crystallize the wisdom of crowds (p26).
Case in point is Maloney & J.H. Mulherin (2003) The Complexity of Price Discovery in an Efficient Market:The Stock Market Reaction to the Challenger Crash:
And Fama-paper (FFJR) The Adjustment of Stock Prices to New Information (1969): Stock prices jumped up on the day that a split was announced, but show no clear direction on the day the split actually occured (p24).
Fama used rule-of-thumb if asked to speak at an event: would I do it if it was next week? (contra hperbolic discounting) (p98).
A prediction market with N=28 students yielded STOC-rankings that correlated about 85% with traditional (extensive & expensive) consumer-survey rankings (Ely et al, 2008).
Frank Knight (1921) introduced useful distinction between risk (randomness that can be measured or quanitfied) and uncertainty (randomness that can't be measured or quanitfied) (p55).
p415: The Adaptive Markets Hypothesis tells us that as we transform uncertainty into risk (e.g. CancerCure bonds), investors will adapt and capital will follow.
Peltzman effect with data (p206): Professor Believes Safer Race Cars Result In More Accidents. New NASCAR safety measures led to more accidents (Sobel & Nesbit, 2007).
Selection works not only on our genes, but also on our social and cultural norms. (p207).
Three key features of the financial ecosystem (p332)
p327: In 2001 important change in the finacial ecosystem. Prior, stock prices/US exchanges moved in discrete units of $0.125. That was changed decimalization, so increments of $0.01. That led to more risk/less easy profits for market makers. ALso, hedge funds undercut market makers. Minor changes in financial environment like decimalization can lead to major changes in the ecosystem.
p354 Culture is very much a product of the environment, and as environments change, so does culture.
Lo is critical on the Israeli judges study (less parole right before lunch due to decision fatigue, p166). Rightly so probably, see e.g. Impossibly Hungry Judges. HOwever, he is quite so critical on the bankers' ethics/dishonesty study (see e.g. Bankers are more honest than the rest of us) or the Kerala fishermen using mobile phones to stabilize market prices (Surprise! Fishermen Using Mobile Phones for Market Prices is the Largest Lie in ICT4D). Perhaps those results are real, but there is some pushback.
p375: complexity of regulations, more interdependencies is more unstable.
Lo argues for something like National Transport Safety Board (NTSB) that -independent & transparant- investigates all (air traffic) accidents and has the whole sector learn from the findings.
Culture can be changed, by changing environment. But call it behavioral risk management (p388)
But: how to measure human behavior?
Eisenbach et al (NY Fed 2015) What Do Banking Supervisors Do?.
DNB (2009) The Seven Elements of an Ethical Culture Strategy and approach to behaviour and culture at financial institutions 2010-2014.
Parting words from Lo (p420): Financie doesn't have to be a zero-sum game if we don't let it.
About one third of variation in investment behavior is attributed to genetics; Barnea, Cronqvist, Siegel (2010)
Nature abhores an undiversified bet (p195) [i.e.: hedge risks most effectively]
Leibowitz (2005) Alpha Hunters and Beta Grazers
J. Doyne Farmer (2002) Market force, ecology and evolution
It also takes a while to get to the main point (the Adaptive Markets Hypothesis in Chapter 6, almost half way in the book). In the chapters before that we get an introduction to (behavioral) economics, and to the theory of evolution. Perhaps because of my background (evolutionary biologist working at a financial regulator), I did not read a lot of new things. Obviously financial markets and evolutionary theory are related...
Plenty of interesting stuff, though, and probably a good starter. Beinhocker's The Origin of Wealth: Evolution, Complexity, And the Radical Remaking of Economics (2006) is probably more in depth (but it is a while since I read that book, plus the financial world has been on a roler coaster since that book was published).
Adaptive Markets Hypothesis
The Adaptive Markets Hypothesis is based on insight that financial markets behave more like biology than physics (p2). The Efficient Markets Hypothesis is not wrong, it is incomplete (p3). The wisdom of the crowds is sometimes overwhelmed by the madness of mobs. Lo introduces it, because it takes a theory to beat a theory. Incidently, John Boggle has the Costs Matter Hypothesis (p265).
p262: Under the AMH, risk isn't necessarily always rewarded, it depends on the environment.
p188:
However, even evolution at the speed of thought hasn't completely adapted to trading at the speed of light (p360).
(ir)rational
Financial behavior that may seem irrational now is really behavior that hasn't had sufficient time to adapt to modern contexts (p9).
p189 (parafrased): Supotimal behavior is going to happen when we take heuristics (rules of thumb) out of the environment in which they emerged (evolved). Not "irrational" but "maladaptive".
Many behavioral biases are the result of our natural human tendency to forecast and plan ahead - but applied to the wrong environment (p66) We are short term demanding and long-term inattentive by nature (p99).
p103 Damasio: to be fully rational, we need emotion. When ability to experience emotions is removed, human behavior becomes less rational (p108; from Damasio (1994) Descartes' Error: Emotion, Reason and the Human Brain).
p117: Human is not a rational animal, but a rationalizing animal (Gazzaniga work).
Efficient markets?
EMH: Prices fully reflect all available information, markets crystallize the wisdom of crowds (p26).
Case in point is Maloney & J.H. Mulherin (2003) The Complexity of Price Discovery in an Efficient Market:The Stock Market Reaction to the Challenger Crash:
Within an hour, the market seems to have placed the blame for the crash on Morton Thiokol, the party ultimately judged by authorities to have been at fault. The firm’s one-day decline of 12 percent was quick, permanent, and reasonably corresponds to the subsequent losses in terms of legal liability, repair costs and lost future business.
And Fama-paper (FFJR) The Adjustment of Stock Prices to New Information (1969): Stock prices jumped up on the day that a split was announced, but show no clear direction on the day the split actually occured (p24).
Fama used rule-of-thumb if asked to speak at an event: would I do it if it was next week? (contra hperbolic discounting) (p98).
A prediction market with N=28 students yielded STOC-rankings that correlated about 85% with traditional (extensive & expensive) consumer-survey rankings (Ely et al, 2008).
Risk & uncertainty
Frank Knight (1921) introduced useful distinction between risk (randomness that can be measured or quanitfied) and uncertainty (randomness that can't be measured or quanitfied) (p55).
p415: The Adaptive Markets Hypothesis tells us that as we transform uncertainty into risk (e.g. CancerCure bonds), investors will adapt and capital will follow.
Selection
Peltzman effect with data (p206): Professor Believes Safer Race Cars Result In More Accidents. New NASCAR safety measures led to more accidents (Sobel & Nesbit, 2007).
Selection works not only on our genes, but also on our social and cultural norms. (p207).
Environment
Three key features of the financial ecosystem (p332)
- Behavior of different species (e.g. banks, hedge funds)
- The environment in which the behaviors take place
- How the two interact and evolve over time (G x E interactions in biology parlance)
p327: In 2001 important change in the finacial ecosystem. Prior, stock prices/US exchanges moved in discrete units of $0.125. That was changed decimalization, so increments of $0.01. That led to more risk/less easy profits for market makers. ALso, hedge funds undercut market makers. Minor changes in financial environment like decimalization can lead to major changes in the ecosystem.
p354 Culture is very much a product of the environment, and as environments change, so does culture.
Debunked?
Lo is critical on the Israeli judges study (less parole right before lunch due to decision fatigue, p166). Rightly so probably, see e.g. Impossibly Hungry Judges. HOwever, he is quite so critical on the bankers' ethics/dishonesty study (see e.g. Bankers are more honest than the rest of us) or the Kerala fishermen using mobile phones to stabilize market prices (Surprise! Fishermen Using Mobile Phones for Market Prices is the Largest Lie in ICT4D). Perhaps those results are real, but there is some pushback.
Regulators
p375: complexity of regulations, more interdependencies is more unstable.
Lo argues for something like National Transport Safety Board (NTSB) that -independent & transparant- investigates all (air traffic) accidents and has the whole sector learn from the findings.
Culture can be changed, by changing environment. But call it behavioral risk management (p388)
But: how to measure human behavior?
Eisenbach et al (NY Fed 2015) What Do Banking Supervisors Do?.
DNB (2009) The Seven Elements of an Ethical Culture Strategy and approach to behaviour and culture at financial institutions 2010-2014.
Parting words from Lo (p420): Financie doesn't have to be a zero-sum game if we don't let it.
Factoids/follow-up reading
About one third of variation in investment behavior is attributed to genetics; Barnea, Cronqvist, Siegel (2010)
Nature abhores an undiversified bet (p195) [i.e.: hedge risks most effectively]
Leibowitz (2005) Alpha Hunters and Beta Grazers
J. Doyne Farmer (2002) Market force, ecology and evolution