Swedroe: Beyond Efficient Markets

August 09, 2017

Andrew Lo is a professor of finance and the director of the Laboratory for Financial Engineering at MIT’s Sloan School of Management.

His research spans a wide range of topics, including the empirical validation and implementation of financial asset pricing models; the pricing of options and other derivative securities; financial engineering and risk management; trading technologies and market microstructure; computer algorithms and numerical methods; financial visualization; statistics, econometrics and stochastic processes; nonlinear models of stock and bond returns; and hedge fund risk-and-return dynamics and risk transparency.

Lo is a co-author of “The Econometrics of Financial Markets,” “A Non-Random Walk Down Wall Street,” “The Heretics of Finance,” “The Evolution of Technical Analysis,” and the author of “Hedge Funds: An Analytic Perspective.”

He is also currently an associate editor of the Financial Analysts Journal, the Journal of Portfolio Management, Quantitative Finance and the Journal of Computational Finance, as well as a co-editor of the Annual Review of Financial Economics.

That’s quite an impressive résumé. Now Lo has turned his attention to evolutionary and neurobiological models of individual risk preferences and financial markets—the subject of his new book, “Adaptive Markets: Financial Evolution at the Speed of Thought.”

The Biology Of Markets

Lo writes: “The Adaptive Markets Hypothesis is based on the insight that investors and financial markets behave more like biology and physics, comprising a population of living organisms competing to survive, not a collection of inanimate objects subject to immutable laws of motion.”

The adaptive markets hypothesis differs from the efficient markets hypothesis in that “it implies that market prices need not always reflect all available information, but can deviate from rational pricing relations from time to time because of strong emotional reactions like fear and greed.”

It further implies that “market risk isn’t always rewarded by market returns” and that “the wisdom of crowds is sometimes overwhelmed by the madness of mobs.”

However, Lo adds, “the madness of mobs eventually subsides and is replaced by the wisdom of crowds—at least until the next shock disrupts the status quo. From the adaptive markets perspective the efficient markets hypothesis isn’t wrong—it’s just incomplete.”

 

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