Adaptive Markets — Andrew Lo
“Human behavior is the ultimate reason accidents happen and become the norm. A prolonged absence of accidents causes people to underestimate the true amount of risk. Over time, in the absence of bad experiences, we lose the capacity to learn from those experiences. As a result, we lose our sense of fear.”
Review:
Some parts intriguing, some parts an absolute slog — Lo’s Adaptive Markets provides the reader with a new way to think about financial markets, delivered in a way your grandfather might spin you a never-ending tale about the old days.
Okay, I might be exaggerating a little. I do understand why Lo went through certain lengths to explain evolutionary history, cognitive biases, and how the Efficient Markets Hypothesis developed over time in academic circles. All of that information serves as a foundation upon which the author can explain his new theory that doesn’t necessarily fully replace the old, but definitely augments it to better reflect reality. However, Lo certainly isn’t one for succinctness, as the reader is forced to humor him and his digressions for at least one hundred plus pages before getting to his actual theory!
I think once you get around to digesting the Adaptive Markets Hypothesis, you’ll appreciate the material that came before it a bit more. Lo essentially says that the EMH is looking at financial markets (and thus all its participants) through an economic lens — one that implies humans make rational decisions all the time, are purely motivated by profit, and will always price all available information into every security. In other words, people are always rational, and markets are rarely ever out of a static equilibrium. While this theory makes sense most of the time, it doesn’t accurately explain human behavior and movements in markets all of the time, particularly during financial crises or bubbles. Lo suggests that we should look at markets through a biological or ecological lens: markets and their participants are constantly adapting to changing technology, regulations, competition, and other aspects of their environment. Instead of being driven just by profit, people are driven by survival. Instead of being purely rational, people develop heuristics that help them navigate a given environment (which can lead to irrational behavior). Instead of the market being in equilibrium all the time with no chance for excess returns, the AMH suggests that everything exists on a continuum that shifts over time in response to the actions of its constituents.
So what does this mean for investors? For one thing, efficiency (and thus alpha) will wax and wane over time. Similarly, risk will be rewarded sometimes and other times it will be punished. This has large implications for investors. If you’re not investing over a long enough time horizon — greater than 20 years perhaps — chances are you are not going to earn the market’s average historical return. If you happen to get caught in an outlier event like Japan’s bubble in the 80s, even a long-term horizon and a passive approach won’t save you from poor returns. Lo is basically saying that the market dynamics and behavior of current participants can actually matter a lot more than any other given factor. As such, he suggests that passive investors control the volatility of their portfolio dynamically as short-term volatility in the market spikes (aka reducing equity exposure when it looks like taking on more risk will not be rewarded). This has given me a few things to think about in terms of asset allocation and passive investing in general.
I think the AMH actually makes a ton of sense and is a better reflection of reality than what the EMH would suggest. I also enjoyed Lo’s discussion at the end of the book on how we might prevent future financial crises and how we can better make finance work for social goals instead of the other way around. However, unless you’re fairly interested in finance and can tolerate a bit of history (both academic and otherwise), I probably wouldn’t recommend this book. It’s a bit too meandering despite how interesting the main point is. If you want a quicker reader, check out the paper.
Score: 6/10
Notes:
· Efficient markets are powerful, practical tools to aggregate information — they do it more quickly and cheaply than any known alternative. Markets gather all information relevant to the future, anticipate all potential changes in the environment, and have prices reflect all available information.
· Many behavioral biases are the result of our natural human tendency to forecast and plan ahead — but applied to the wrong environment. While forward-looking behavior and planning ahead are the most powerful human abilities we have (and a main reason we are the dominant species), when they are used in ways never intended they can lead us to do silly things.
o Representativeness heuristic — taking a small sample as representative of the whole
o Affect heuristic — personal fears cause us to exaggerate risks that viscerally affect us; causes us to magnify risks in troubled times and be overly optimistic in happier times
· The brain applies the same neural circuitry of fear and greed to financial experiences as it does to everything else
o We’re essentially using old parts of our brain to respond to new ideas, which can result in frequent mishaps and suboptimal behavior
o Compared to the perfectly rational Homo economicus, we’re more impulsive over the short term and more logical over the long term
o However, this isn’t to say our emotions are the cause of irrational behavior themselves; rational behavior is a balancing act between emotions like fear and greed — when one gets out of control, that is what leads to irrationality
o We are also subject to bounded rationality — our brains can operate instantaneously or indefinitely, they can’t multi-task very well, they have problems planning scenarios several moves ahead or at several degrees of theory of mind, and they will sooner construct a plausible story than admit ignorance
· Evolution applied to ideas is the reason why abstraction and language have been so important for human success. They allow for the formulation of more complex ideas within an individual, and then the transmission of those ideas from person to person. This allows our species to organize its behavior on an unprecedented scale.
o Natural selection applies to narratives as well as to genes
o The evolution of ideas, accomplished at the speed of thought, is at the heart of what separates us from other species
o The ability to engage in abstract thought, to imagine counterfactual situations, to come up with new heuristics individually and collaboratively, and to predict the consequences, is uniquely human
· The Hypothesis
o We are neither always rational nor irrational, but we are biological entities whose features and behaviors are shaped by the forces of evolution
o We display behavioral biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback
o We have the capacity for abstract thinking, predictions about the future based on the past, and preparation for changes in our environment; this is evolution at the speed of thought
o Financial market dynamics are driven by our interactions as we behave, learn, and adapt to each other, and to the social, cultural, political, economic, and natural environments in which we live
o Survival is the ultimate force driving competition, innovation, and adaptation; individuals make choices based on their past experience and their best guess as to what might be optimal; as a result of the feedback they get, individuals will develop new heuristics to help them solve their economic challenges
· Long term averages can hide many important features of the financial landscape, especially when the long term is so long that it includes radically different financial institutions, regulations, political and cultural mores, and investor populations
o Not only is the average deceiving, but investors typically aren’t fully invested over these long horizons and will most likely not earn these returns
o The AMH tells us that risk isn’t necessarily rewarded — it depends on the environment; stocks for the long run may not be good advice depending on where you’re investing, for how long, and what your risk tolerance is (ex: Japan post-bubble)
o Sustainable risk premiums may be available for a period of time, given the financial environment and the population history of the market — in other words, market dynamics matter more than any static equilibrium
o Lo suggests combining a passive index with some form of volatility “cruise-control,” in which the investor would scale back stock exposure when short-term volatility spikes so as to keep the target level of portfolio volatility relatively stable; this seems to improve risk-adjusted returns
· AMH implies that market efficiency (and thus alpha) isn’t an all or nothing condition, but a continuum
o Efficiency depends on the relative proportion of market participants who are making investment decisions with their prefrontal cortexes to the ones relying on their more instinctive faculties
o The degree of efficiency is related to the degree a given set of participants is adapted to the environment in which the market has developed (i.e. relatively new markets are likely to be less efficient than very old ones, but dynamics can change that)
o Stock market predictability isn’t stable — it waxes and wanes, instead of declining steadily over time like the EMH would suggest
· Principles, continued
o During normal market conditions, there’s a positive association between risk and reward; however, when the population is comprised of investors facing extreme financial threats, they can act irrationally in concert and punish risk; these periods can last for years
o CAPM and linear models rely on key economic and statistical assumptions that may be poor approximations in certain market environments; knowing the environment and population dynamics may be more important
o Portfolio optimization tools are only useful if assumptions of stationarity and rationality reflect reality; risk management should be a higher priority for passive investors
o The boundaries between asset classes are becoming blurred, as macro factors and new institutions are creating links/contagion that didn’t exist before; the power of asset allocation to reduce risk may be lower than in the past (ex: Quant meltdown of 2007)
o Few investors can afford to invest over the very long run and capture average returns; investors should thus be more proactive about managing risk over shorter time horizons
· Preventing crises
o Need to use better technology to understand the complexity of regulations and design a better system that can adapt to growing complexity of the financial world
o Mapping financial networks to show how losses could be transmitted among unexpected financial linkages is important (ex: seeing when correlations in returns rises among different institutions); this could allow us to quarantine them before contagion spreads
o Need an NTSB equivalent independent party for the financial world that dissects past financial crises, communicates issues to the public, gathers information, and analyzes what steps need to be taken to prevent future calamities
o Need to reshape culture (aka manage behavioral risk) in financial institutions or adapt them to deal with the heuristics we are prone to using
Phrases/Quotes:
· A hedge fund is a private partnership that has a start and an end, and involves a general partner and several limited partners, each of whom brings something to the partnership. At the start, the general partner brings all the experience and limit partners bring all the money. At the end, the general partner leaves with all the money and the limited partners leave with all the experience.
· Human behavior is the ultimate reason accidents happen and become the norm. A prolonged absence of accidents causes people to underestimate the true amount of risk. Over time, in the absence of bad experiences, we lose the capacity to learn from those experiences. As a result, we lose our sense of fear.
