{"id":12328,"date":"2017-05-19T08:07:52","date_gmt":"2017-05-19T08:07:52","guid":{"rendered":"http:\/\/revoscience.com\/en\/?p=12328"},"modified":"2017-05-19T08:07:52","modified_gmt":"2017-05-19T08:07:52","slug":"darwin-visits-wall-street","status":"publish","type":"post","link":"https:\/\/www.revoscience.com\/en\/darwin-visits-wall-street\/","title":{"rendered":"Darwin visits Wall Street"},"content":{"rendered":"

Andrew Lo\u2019s new book urges a rethink of financial markets, along evolutionary lines.<\/strong><\/em><\/span><\/p>\n

\"\"
\u201cAdaptive Markets,\u201d by Andrew Lo, published by Princeton University Press
Photo: Jason Dorfman<\/figcaption><\/figure>\n

CAMBRIDGE, Mass. —\u00a0If you have money in the stock market, then you are probably anticipating a profit over the long term \u2014 a rational expectation given that stocks have historically performed well. But when stocks plunge, even for one day, you may also feel some fear and want to dump all those stress-creating equities.<\/span><\/p>\n

There is a good reason for this: You\u2019re human.<\/span><\/p>\n

And that means, to generalize, that you have both a rational side and some normal human emotions. To Andrew Lo, the Charles E. and Susan T. Harris Professor and director of the Laboratory for Financial Engineering at the MIT Sloan School of Management, accepting this basic point means we should also rethink some common ideas about how markets work.<\/span><\/p>\n

In economics and finance, after all, there is a long tradition of thinking about investors as profit-maximizing rational actors, while imagining that markets operate near a state of perfect efficiency. That sounds nice in theory. But evidence shows that this view is not sufficient for understanding the radical swings that market sentiment creates. \u00a0<\/span><\/p>\n

\u201cWhen you and I are making investment decisions independently, we\u2019ll exhibit different behavior,\u201d Lo says. Those varied decisions help keep markets stable, most of the time. \u201cBut when we all feel threatened at the same time, we\u2019re likely to react in the same way. And if we all start selling stocks at once, we get a market crash and panic. Fear can overwhelm rationality.\u201d<\/span><\/p>\n

Now Lo has written a new book about the subject, \u201c<\/span>Adaptive Markets<\/a>,\u201d published this month by Princeton University Press. In the book, he draws on insights from evolutionary theory, psychology, neuroscience, and artificial intelligence to paint a new picture of investors. Instead of regarding investors simply as either rational or irrational, Lo explains how their behavior may be \u201cmaladaptive\u201d \u2014 unsuited to the rapidly changing environments that shifting markets present.\u00a0\u00a0<\/span><\/p>\n

In so doing, Lo would like to resolve the divergence between the realities of human behavior and the long-standing \u201cefficient markets hypothesis\u201d (EMH) of finance with his own \u201cadaptive markets hypothesis,\u201d to account for the dynamics of markets \u2014 and to provide new regulatory mechanisms to better ward off damaging crashes.<\/span><\/p>\n

\u201cIt takes a theory to beat a theory,\u201d Lo quips, \u201cand behavioralists haven\u2019t yet put forward a theory of human behavior.\u201d<\/span><\/p>\n

Path-dependent<\/strong><\/span><\/p>\n

To get a grip on Lo\u2019s thinking, briefly examine both sides of the EMH debate. On the one hand, markets do exhibit significant efficiencies. Do you own a mutual fund that tracks a major stock-market index? That\u2019s because it is very hard for individual investors or fund managers to beat indexes over an extended period of time. On the other hand, based on what we know about market swings and investor behavior, it seems a stretch to think markets are always efficient.<\/span><\/p>\n

\u201cThe EMH is a very powerful theory that has added a great deal of value to investors, portfolio managers, and regulators,\u201d Lo says. \u201cI don\u2019t want to be viewed as criticizing it. What I\u2019m hoping to do is to expand its reach, by explaining under which conditions it\u2019s likely to work well, and under which other conditions we require a different approach.\u201d<\/span><\/p>\n

As Lo notes in the book, the EMH assumes that individuals always maximize their expected utility \u2014 they find the optimal way to spend and invest, all the time. Lo\u2019s adaptive markets hypothesis relaxes this dictum on two counts. First, a successful investing adaptation doesn\u2019t have to be the best of all possible adaptations \u2014 it just has to work fairly well at a given time.<\/span><\/p>\n

And second, Lo\u2019s adaptive markets hypothesis does not hold that people will constantly be finding the best possible investments. Instead, as he writes in the book, \u201cconsumer behavior is highly path-dependent,\u201d based on what has worked well in the past.<\/span><\/p>\n

Given those conditions, the market equivalent of natural selection weeds out poor investment strategies, Lo writes, and \u201censures that consumer behavior is, while not necessarily optimal or \u2018rational,\u2019 good enough.\u201d Not perfect, but decent.<\/span><\/p>\n

In this light, consider fund managers who do beat the big stock indexes for a while. In many cases, their successes are followed by years of poor performance. Why? Because they did not keep adapting to a changing investing environment. This familiar dynamic, Lo contends, is one reason we should drop the physics-inspired notions of the market as an efficient mechanism, and think of it in evolutionary terms.<\/span><\/p>\n

Or, as Lo writes in the book, \u201cbiology is a closer fit to economics than physics.\u201d As the physicist Richard Feynman put it, \u201cImagine how much harder physics would be if electrons had feelings.\u201d<\/span><\/p>\n

Looking for policy impact<\/strong><\/span><\/p>\n

\u201cAdaptive Markets\u201d does not represent the first time Lo has put some of these ideas into print. It is the culmination of a long-term line of inquiry, and the most detailed, extended treatment he has given to the concept.<\/span><\/p>\n

Lo says his hope for the book, however, is not just to change some minds among the public and other scholars, but to reach policymakers. Having served on multiple government advisory panels about regulation, Lo believes we need regulations that are more generally focused on limiting risk and large-scale crashes, rather than seeking to assess the legitimacy of umpteen new financial instruments.<\/span><\/p>\n

The analogy Lo likes to make is that finance needs an equivalent of the National Transportation Safety Board, the federal agency that investigates the systemic causes of aviation accidents, among other things, and whose existence has helped engender a period of unprecedented air safety.<\/span><\/p>\n

Even in the run-up to the 2008 financial-sector crisis, Lo contends, the notorious bond markets trading securities backed by subprime mortgages, and their derivatives, were not deeply \u201cirrational.\u201d After all, those markets had winners as well as losers; the problems included the way the markets were constructed and the opportunity for firms to wildly increase their risks while seeking big payoffs.\u00a0<\/span><\/p>\n

\u201cIt\u2019s not so much that market prices were wrong, it\u2019s that the policies and incentives were flawed,\u201d Lo contends.<\/span><\/p>\n

That might generate some heated debate, but Lo says it is a discussion he welcomes.<\/span><\/p>\n

\u201cWe aren\u2019t really getting traction arguing either for or against efficient markets,\u201d Lo says. \u201cSo maybe it\u2019s time for a new perspective.\u201d<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

Andrew Lo\u2019s new book urges a rethink of financial markets, along evolutionary lines. CAMBRIDGE, Mass. —\u00a0If you have money in the stock market, then you are probably anticipating a profit over the long term \u2014 a rational expectation given that stocks have historically performed well. But when stocks plunge, even for one day, you may […]<\/p>\n","protected":false},"author":6,"featured_media":12329,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[34,22,17,32],"tags":[],"class_list":["post-12328","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-economics","category-other","category-research","category-social-science"],"featured_image_urls":{"full":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"thumbnail":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0-150x150.jpg",150,150,true],"medium":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0-300x200.jpg",300,200,true],"medium_large":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"large":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"1536x1536":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"2048x2048":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"ultp_layout_landscape_large":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"ultp_layout_landscape":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"ultp_layout_portrait":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",600,400,false],"ultp_layout_square":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",600,400,false],"newspaper-x-single-post":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"newspaper-x-recent-post-big":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",540,360,false],"newspaper-x-recent-post-list-image":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",95,63,false],"web-stories-poster-portrait":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",639,426,false],"web-stories-publisher-logo":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",96,64,false],"web-stories-thumbnail":["https:\/\/www.revoscience.com\/en\/wp-content\/uploads\/2017\/05\/MIT-Adaptive-Markets_0.jpg",150,100,false]},"author_info":{"info":["Amrita Tuladhar"]},"category_info":"Economics<\/a> Other<\/a> Research<\/a> Social Science<\/a>","tag_info":"Social Science","comment_count":"0","_links":{"self":[{"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/posts\/12328","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/users\/6"}],"replies":[{"embeddable":true,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/comments?post=12328"}],"version-history":[{"count":0,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/posts\/12328\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/media\/12329"}],"wp:attachment":[{"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/media?parent=12328"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/categories?post=12328"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.revoscience.com\/en\/wp-json\/wp\/v2\/tags?post=12328"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}