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 But , what if we are operating our financial system on understandings of behavior that are wrong or out-of-date , and bound to fail again ?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