BOOK REVIEW
BY JAMES P. PROUT
Adaptive Markets: Financial Evolution at the Speed of Thought
By Andrew W. Lo Princeton University Press 2017 483 pages, with photographs, notes and index $ 37.50
The last 15 years or so haven’ t been a good time for modern economic theory. Stuff just hasn’ t worked out the way a lot of economists said it should. Never-beforeseen low interest rates haven’ t resulted in roaring growth, only a grudging,“ meh” recovery. Wages are stuck in neutral, even though we’ ve been at what’ s called“ zero unemployment” for a while. Free trade is out; Smoot and Hawley are in.
This apparent confusion over which economic theories work and which don’ t also applies to financial markets. As I write this, equity markets keep hitting new highs, but economists and policy makers are still arguing over what went wrong in 2007 – 8 and whether the regulatory and monetary responses to the meltdown were helpful or harmful.
Of course, nobody wants to take the punch bowl away in the middle of the party, and maybe economic theories don’ t matter in the real world. But, what if we are operating our financial system on understandings of behavior that are wrong or out-of-date, and bound to fail again? With all that has happened, do we fully understand what motivates market actors at any given point in time and in diverse environments?
Into this confusion bravely steps Andrew Lo, a distinguished finance professor at MIT, with his book, Adaptive Markets: Financial Evolution at the Speed of Thought. Lo challenges some of the financial markets’ most dearly held tenets and suggests how new research into neuro-science and cognitive studies reveal greater insight into market behavior. He posits an Adaptive Markets Hypothesis which, he asserts, might be a path to a truer understanding of how financial markets really work, and how they can be harnessed for the greater good.
Lo spends the first couple of chapters setting out a history of economic theory on financial markets. This includes wellknown and more obscure commentators, most of whom came at markets largely by observing behavior and extracting theories which purported to explain why choices were made as they were. This was an inductive process, attempting to discover broad concepts based on observable action. It was by its nature more philosophical and far less data driven than some in the economics world liked.
Beginning around the time of Samuelson, every self-respecting economist
( and certainly those who wanted tenure) had to be mathematically inclined, the more complex and dense the better. Formulas and math took the place of observation and experience. From this came the“ lodestones” of financial market thought, namely the Efficient Market Theory( prices reflect all that is known about an asset) and the Random Walk Theory( impossible to“ beat” the market over time). Man has evolved into a higher being: Homo Economicus— where individuals are always choosing to maximize their economic future.
For Professor Lo, and others such as Daniel Kahnemann and Amos Tversky, these theories are at odds with reality. Too many people, and too many institutions, make selections that do not at all reflect accurate assessment of facts, values and trends. Citing studies large and small, Lo argues that, often times, blind reliance on the certainty of existing theories is a trap. For example, his studies show that the“ randomness” of returns— which should track the length of time an investment is held— does no such thing; it actually increases the longer movement is measured.
Unlike many economists, Lo has a human side( he grew up in Queens, after all) which he is not afraid to talk about. Economic actors have emotions, and they often revert to rules of thumb( heuristics) to handle unfamiliar situations. Mechanical, physical or mathematical laws really can’ t explain how humans behave. Biology, perhaps, might be a better model to explain the complex factors that motivate people regarding risk and reward, pain and pleasure.
Evolution and adaptation are the hallmarks of biology, and understanding these processes give greater insight to how markets and market participants shift and grow. To illustrate, Lo cites work done measuring the brain patterns of traders as they win or lose.
This all leads to Lo’ s theory of Adaptive Markets, where he suggests a variation / improvement on existing theory. Markets and market participants are not static. They do not act in vacuums. Instead, their
38 FINANCIAL HISTORY | Fall 2017 | www. MoAF. org