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Adaptive Markets: Financial Evolution at the Speed of Thought
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Half of all Americans have money in the stock market, yet economists can't agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe - and as financial bubbles, crashes, and crises suggest.Â
This is one of the biggest debates in economics, and the value or futility of investment management and financial regulation hang on the outcome. In this groundbreaking book, Andrew W. Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist.Â
Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, Adaptive Markets shows that the theory of market efficiency isn't wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit. Lo's new paradigm explains how financial evolution shapes behavior and markets at the speed of thought - a fact revealed by swings between stability and crisis, profit and loss, and innovation and regulation.
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Audible Audiobook
Listening Length: 20 hours and 21 minutes
Program Type: Audiobook
Version: Unabridged
Publisher: Tantor Audio
Audible.com Release Date: January 18, 2018
Whispersync for Voice: Ready
Language: English, English
ASIN: B078JTLDJQ
Amazon Best Sellers Rank:
Adaptive Markets is an excellent book on the nature of markets and economics as a field broadly. There is a lot of content in the book and it starts from first principles and discusses comprehensively the field of financial economics and where it stands today. The author brings his originality in thinking about the nature of markets and people to the general audience with a lucid discussion of both behavioral and mathematical finance and both of their merits and failures. The author describes how markets are evolutionary in nature and the background market place does not exist in a vacuum and this evolutionary nature is why markets can be both efficient in a particular regime but fragile to a change in regime. There is much to think about in reading this book but it is well worth the effort.The book is split into 12 chapters and include a lot of material and ideas. To set the stage the author gives the philosophical background of most modern economists which have followed in the footsteps of Paul Samuelson who helped mathematize economics. The base assumption of financial economists are that people act rationally and their decisions are constant manifestations of the attempt to maximize their utility. The author discusses some of the implications of this, in particular the game theory associated with common knowledge as well as some impressive example of when markets lead to remarkably quick processing of events and their implications on value changes in equity prices. The author spends time discussing behavioral finance and things like loss aversion and the importance of framing questions. The author gives case studies of where behavior looks irrational from an expectation maximization perspective. In particular he discusses how people use probability matching as a default heuristic for most people when making bets, say in a game where you get paid on heads and pay on tails and the odds of heads are 3/4 to 1/4 people make bets in relative frequency of 3/4 heads, 1/4 tails rather than 100% heads despite the superiority of such a strategy. The author also discusses some of the biological consequences of gambling and trading. As we can now monitor physiological changes as a consequence of realizing gains and losses for professional investors and traders, the results show that our emotional states are affected by dealing with gains and losses and certain people have trained themselves to deal with this better but the idea that we calculate odds equivalently in all mental states is empirically false. The author discusses results from neuroscience and results from split brain research. One key result is how our minds create narratives to make sense of the world and successful prediction depends on how one creates narratives that frame cause and effect in the world we live in. As a final background chapter the author discusses principles of evolution and the scientific record of man as well as on how brain structure evolved. The book is filled with results that help frame both ideas from behavioral finance as well as from traditional efficient market financial economics.The author moves from the background information to the core of his fresh ideas which he calls the adaptive market hypothesis. The author reminds the reader that despite the clear failures of people to live up to the ideal calculation agent that is homo economicus, academic fields require a new theory before discarding an old one. Describing counterexamples to assumed behavior just isn't good enough. The adaptive market hypothesis is, among many things, the idea that people develop heuristics to the market environment that are successful, but that the environment in which those heuristics are effective is always changing both due to the behavior of individuals changing as well as to exogenous factors. The author highlights how matching probabilities is a successful strategy in which the population is trying to maximize its size in an environment which changes state unpredictably even though such a strategy does not maximize the individuals survival. The author discusses how efficient markets and adaptive markets fundamentally differ in that adaptive markets don't have a general equilibrium. They might have a local equilibrium where that equilibrium is dependent on nothing changing but the world is always changing so behavior and what is right and wrong as a strategy is always adapting. It is a very compelling idea, that what drives markets and what is a successful strategy in markets is always changing as the landscape is evolutionary and adaptation is immediate rather than generational as knowledge is transferred at the speed of thought.The author uses hedge funds to highlight the evolutionary nature of markets describing how varying strategies can be effective and that strategies which were successful no longer need be. The author also discusses the results of his analysis of the quant meltdown in 2007 which is very interesting as he charts the profit and loss function from mean reversion trading and its huge change in outcome during the summer. The author highlights how certain things can self reinforce one another but are then very fragile to regime shift. The author spends time on discussing the fact that markets don't exist in isolation and that the ethics of markets can be dependent on their structure so that setting up markets correctly can impact the social outcomes. The author spends some time as well on some partial solutions to finance today and how markets are remarkable systems that can solve problems when properly applied. The author discusses global warming, longevity, poverty and how finance could be used to solved with appropriate funding solutions that diversified risks.Adaptive markets puts a lot of material together to form a theory of markets as an evolutionary social construction. It uses the ideas from efficient markets, behavioral finance, neuroscience, evolutionary biology and evolutionary game theory to frame how to view the reality of investing in financial markets. A lot of the background material lies elsewhere and the author cites these authors and books but the work is self contained despite the broad base of subjects included. I definitely think this is a work of very high quality from a very well respected academic. There are small parts which meander a bit but the author weaves the subjects together to give a coherent overview of a complex subject and frames his thesis and evidence well. Highly recommend.
For a scholar who writes of his early life: "In second grade, my mother received a note from my teacher informing her that I might be “retardedâ€â€”the term of art in those days—and could use some extra help." P. 125 --- Welcome to a marvelous book by Andrew W. Lo. (I love authors with an ability to express a self-deprecating sense of humor!).From the book jacket --- Andrew W. l.o is the Charles E. and Susan T. Harris Professor of Finance at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. He is the author of Hedge Funds and the coauthor of A Non-Random Walk Down Wall Street and The Econometrics of Financial Markets (all Princeton University Press). He is also the founder of AlphaSimplex Group, a quantitative investment management company based in Cambridge, Massachusetts.What's great about this book are several things:1. You do NOT have to be a graduate student in Finance at MIT to enjoy this book. If you enjoy cutting edge multi-disciplinary insights into human behavior, this book is for you.2. This book requires unlearning - for me, authors that do this are rare and invaluable.3. This book FINALLY begins the arduous process of integrating the science from a multitude of fields into a coherent thesis: :"A new explanation for the contradictions and paradoxes discovered in the battle between the rationalists and the behavioralists. I call this new explanation the Adaptive Markets Hypothesis." P. 185.4. The author is a superb story teller with no intellectual ax to grind. His wonderful heart comes through in the way he writes...it just makes the reading experience vastly more enjoyable. Thank you.The nature of our understanding of economics, finance and human behavior is changing (as it must). As one who enjoys writing and research in this genre, I find, as the author states; "But every time I finished one book, I felt impelled to read another because of gaps or inconsistencies in what I’d just read." P. 302 Adaptive Markets put an end to this experience for me (although I WILL continue reading!!!).That's why Adaptive Markets – Financial Evolution at the Speed of Thought - by Andrew W. Lo is so darn important. The work is very much an integration of the most compelling scientific findings from a myriad of fields that Lo sutures together in a straightforward and coherent manner. It is also a body of work that will undoubtedly inspire additional research.Evolutionary biology represents an organizing framework for Lo's reasoning. I found the framework very illuminating. A few quotes from the book:"The Adaptive Markets Hypothesis tells us that profit-taking alone isn’t enough to explain market success in organizing human behavior. We’re motivated by fear and greed, but also by a sense of fairness, and perhaps most important, by our imaginations." P. 417"Just as the human eye is susceptible to optical illusions, the human brain is susceptible to illusions about risk and probability." P. 62"Economic rationality isn’t wrong; it’s just incomplete." P. 200"Financial evolution proceeds at the speed thought, where several generations of ideas can come and go within the time span of a productive working lunch." P. 231"A financial crisis can be as disruptive to people’s lives as a major war." P. 320"This means that culture is also subject to evolution, to the same processes of variation, selection, and replication as a biological species or a mental narrative". P. 345"There are important interactions between culture and environment, in some cases reinforcing bad behavior." P. 352.This is a terribly important work. I hope it will inspire the essential, civil dialog and research endeavors that are currently woefully underfunded to explore the emerging, new frontiers in finance - and our understanding of all the audiences in these environments.I HIGHLY recommend this superb work. LOVED IT!!!ENJOY!
If you ignore the uber-geekiness and wordiness of a few sections, you will find many unique insights. For example, did you know the 2008 financial crisis wasn't a product of regulators loosening leverage restrictions? Everyone from CNN to Barry Ritholtz (in Bailout Nation) propagated this reasoning, and it's a myth. Only Andrew Lo has been brave enough to brazenly take on the Establishment in this regard: "Lehman's debt-to-assets ratio had been high since the late 1990s... What these [financial] conflagrations all have in common are new connections between previously unrelated assets. The construction of a shared pool of mortgages creates a tight coupling... in the financial system where none existed before."Before you think Lo is a pro-government academic, he then lambasts the SEC's handling of Madoff's pyramid scheme with information I've never seen before: "The OCIE and NERO conducted two separate, independent examinations of Madoff. Each examination was unaware of the other, until Madoff himself informed examiners of their mutual existence."Finally, the very last chapter--about using finance to cure cancer--is a must-read. Lo's Adaptive Markets could have used a more firm editor, but you can skip the sections on statistical analysis to get a better overall reading experience.
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