Where the Wild Things Are – Adaptive Markets: Financial Evolution at the Speed of Thought
Welcome to Andrew Lo’s frenetic financial zoo.
Traders and investors, especially the hifalutin’ quant sort, tend to idolize — even fetishize — fields like astrophysics, nonlinear dynamics and engineering. Synthesizing scientific ideas and terms such as ‘logarithmic scales’, ‘multiple disequilibria’, ‘M2 velocity’ and ‘jump diffusion’, financial economists are obsessed with ‘mathematicizing’ — in Newtonian terms — our ridiculously complex and wobbly world. But a brand new book by Andrew Lo, VIVISXN’s favorite finance/econ egghead, makes the claim that biology, not physics, should be the profession’s commanding paradigm.
The central idea links to “behavioural economics” — a faddish field of enquiry that examines humans not as hyper-rational, utility-maximizing Vulcans with Spock-like savvy, but rather beings imbued with logical kinks and cognitive quirks that rely on ‘bounded rationality’ and ‘satisficing.’ Professor Lo basically reconciles ‘the random walk‘ with behavioral and post-modern finance. His work essentially amounts to a new school of thought — call it “quant psych” — where psychology and subsets of AI (machine learning, fintech, etc.) come together to give economic actors an ‘adaptive edge.’
Professor Lo, a badass MIT professor, has spent about two decades delving into the faults and foibles of “efficient market” orthodoxy. Fusing computational methods with sociobiology, his eureka idea — built on bucketloads of econometric data and multidisciplinary brainstorming — is the “adaptive markets hypothesis”, or AMH. This theory argues that individuals are driven by conceptual shortcuts and problem-solving heuristics — rules of thumb and ‘guesstimations’ that are hard-wired into our brains. If the guesstimations go bad, we dynamically adapt our behavior to optimize outcomes. If it happens again, we re-factor and re-optimize our ‘narratives’ for better results, ad infinitum.
The theory dovetails with psychology and how humans make tough decisions, especially in the domains of probability matching and risk-taking. Information is inherently asymmetrical and humans (herds included) thus have a tendency to interpret patterns from random data and iffy abstractions. This evolutionary trait, however, is especially hard when making dicey, binary decisions, say, buying a stock, short-selling a bond or speculating in currency options.
Emotions — quick-fire subconscious calculators giving us the sum of our profits or losses — play a profound role in evaluating risk and reward, “acting as a joy-and-suffering system that enables the brain to select an advantageous behavior.”
Greed and fear, along with pleasure and pain, are mediated by our actions and reactions. If we do not fear the consequences of failure, for instance, we may act irrationally, just as a small child must look both ways before crossing the street or risk being squashed like a bug. Individuals with impaired thinking, i.e. brain damage (such as the infamous case of H.M.) demonstrate that “when the ability to experience emotions is removed, human behavior becomes sub-optimal.”
Echoing the great evolutionary biologist E.O. Wilson, modern economies function like natural ecosystems complete with competition, natural selection, and extinction events, in which market participants interact with each other to produce a kind of lighting-fast feedback loop. Economic agents such as hedge funds and ‘algo traders’ — in all their complex styles and quant strategies — evolve at the “speed of thought” and collectively comprise what Professor Lo calls the “Galapagos islands of finance,” a social-economic sphere in which speciation, mutation and extinction are unfolding all the time.
The AMH sheds light on the nature of volatility and why financial markets can be in state of ‘risk homeostasis’ one second and then shift violently to a different ‘risk regime’ the next. Booms and busts are brought about by the collision of subjective value judgments and systematic biases: “Economic expansions and contractions are the consequences of individuals and institutions adapting to changing financial environments, and bubbles and crashes are the result when the change occurs too quickly.”
Regulators like FINRA, the SEC and the CFTC are usually in a state of arrested development (“always one or more evolutionary steps behind”), unable to keep up with their speedball subjects. The solution is to create a body of “adaptive regulators”, like America’s National Transportation Safety Board (NTSB), an independent watchdog that assesses transportation accidents and recommends clever fixes.
Dr. Lo dishes out a few heterodox ideas on pharma investing and cancer treatment as well. He wants to construct jumbo portfolios (à la hedge fund style) with highly diversified positions of designer drugs and biotech startups. This financial engineering of early stage pharma through equity and debt issuance would reduce risk, boost returns and potentially cure deadly illnesses. A lofty idea indeed.
Andrew Lo’s Adaptive Markets is full of brilliant insights into group behavior, evolution, artificial intelligence and human fallibility — and our innate tendency to engineer quick solutions and arbitrage inefficiencies away. A must read! The book’s only shortcoming is its dearth of stochastic partial differential equations. Oh well. We love anyway!
Adaptive Markets: Financial Evolution at the Speed of Thought. By Andrew Lo. Princeton University Press; 483 pages; $37.50 – buy it here.
VIVISXN – Finance + Economics + Culture