This book offers a welcome, fresh look at how financial markets work and why they sometimes fail. It is ambitious work to say the least. Lo first sets out to reveal the inadequacies of the long dominant and purely rationalistic efficient markets hypothesis (EMH) of finance. Then, with his own adaptive markets hypothesis (AMH), he offers a cogent expansion of this thinking to accommodate emotion and irrationalities, in other words, reality. He succeeds in general, though he sometimes disappoints by oversimplifying what he wishes to criticize, overstating the originality of his own insight, and, on at least one occasion, ignoring the implications of one of those insights. Still, a book this complex and wide ranging could hardly avoid a few lapses.
Several times Lo’s insistence on both emotion and rationality brought me back to the shock of September 11, 2001. The offices where I worked at the time, though at some distance from the World Trade Center, offered a full view of events that ugly morning. I remember that when I saw the first tower fall, I denied the evidence before my eyes, a natural, human response that Prof. Lo explains well. When in the next instant I accepted the horror of reality, I had an impulse to run, not out of the room but out of New York to start a new life in the relative safety of the flyover. That response, too, Prof. Lo shows is natural. Yet, even as I quickly contemplated life on the farm, my many years in finance raised a very different reaction. Now, it occurred to me, is the time to get a good price on a Manhattan apartment. Only that cold, very cold reaction to disaster reflected the pure rationality of the efficient markets approach. Otherwise, it informed nothing of what went through my mind.
Because Adaptive Markets is a reaction to the narrowness of prevailing financial thought, it begins, appropriately, with a detailed history of how that thinking developed. Lo’s careful treatment even includes brief biographies of some of the theory’s leading lights, many of them Nobel Laureates. As Lo describes it, these thinkers see markets as guided by a purely rational creature, homo economicus he calls it, who feels neither fear nor triumph but continually weighs opportunities against risks in order to optimize his strategies, purchases, sales, and holdings. The implication of this line of reasoning, at least if taken to its logical extreme, is that markets become such efficient processers of information that no individual can find an opportunity not already exploited. With no hope of getting ahead of this calculating machine, investors, according to a strict reading of the EMH, might as well give up the effort and passively invest in a broad range of assets, index in the current jargon.
Having characterized dominant financial thought in this way, Prof. Lo then sets out to show how very limited it is, and by implication the need to broaden it, as he has done. That effort directs three of his twelve chapters, over 100 pages, to review contrary evidence from neuroscience and evolutionary theory. There, he demonstrates beyond cavil that people often make less than fully rational choices and, what is more, offers convincing reasons why. Of course, human irrationality should hardly come as news to anyone who has ever dated or attended a family reunion, but the scientific evidence creates a compelling need to go beyond the simple acknowledgement that emotion exists and incorporate it into financial theory.
This part of the effort to discredit the EMH, impressive and enlightening as it is, nonetheless fails to do so as thoroughly as Prof. Lo implies. He does show conclusively that no individual is entirely rational and why, but the reigning theory never actually makes the claim that individuals are rational. Rather, it argues that at any moment enough market participants can dispassionately assess the available information to move markets toward rational conclusions. Except when there is a shock to the system, emotional influences, lying on all sides of the investment equation, effectively cancel each other out. Reason prevails. Though Prof. Lo acknowledges this aspect of the EMH elsewhere in his book, he disappointingly fails to do so when using evidence of individual irrationality to discredit it.
Sometimes, he even seems to stack the deck to create critical evidence. One experiment, for instance, examines currency traders for levels of emotion on the job. The tests seem valid enough, but Lo surely knows that traders do not move markets. They execute decisions made by others off trading floors sometimes arrived at over the course of several days or weeks. Warren Buffett, George Soros, and others, toward whom Lo shows something close to awe, reach their conclusions only after due deliberation in offices and investment meetings, not sitting in trading turrets. To be sure, psychological experiments at that level would be hard to contrive, but it is there, not with traders, where he must look to find market-moving emotion.
If such failings weaken Lo’s case, it finds firmer footings when he discusses overall market irrationalities, such as during the 2008-09 financial crisis. It is around such incidents that he constructs the most convincing and welcome aspects of his adaptive market hypothesis. Here he draws on the psychological work of Herbert Alexander Simon, who demonstrated decades ago the psychological impossibility of optimization. Reality, Simon made clear, simply presents too many possibilities, even in stable environments, even in “very limited situations.” Instead of the thorough analysis and optimal choice suggested by the EMH, people tend to rely, Simon argued, on rules of thumb that simply work well enough. They develop these heuristics, as Lo calls them, over time to suit a particular environment. As long as the environment in which they develop remains relatively stable, things seem to follow a rational path. But when the environment changes, these heuristics break down, chaos reigns, rationality evaporates, and more basic, fight-or-flight sorts of instincts prevail. Rationality and order only seem to return when people can develop new heuristics better suited to the new environment.
This insight alone offers a number of ways to broaden financial thinking. To be sure, some financial practitioners might belittle it. They might claim, with some justice, that they have long anticipated Lo’s criticisms of the EMH and that he has done little more than describe how they bend the rationalist hypotheses daily to suit the reality. It is true that practice has never accepted strict interpretations of the EMH. Practitioners have long known that even in stable environments it takes time for markets to approach a semblance of the efficiencies described by the EMH. They use the delay to capitalize on opportunities of which the strictest application of the theory denies the existence. They have also long observed, as Lo also points out, that it takes longer than the rationalist theory suggests for riskier assets to pay the superior returns it logically promises. Practitioners, accepting the link between risk and return, nonetheless tell investors that the superior returns of risky assets are only for people who can do without the money for years. They usually speak in terms of ten-year intervals and would criticize Lo’s almost gleeful finding that the relationship breaks down over five-year intervals as proof of nothing, least of all their application of EMH principles.
Even if these practitioners are correct at every turn, that they have long anticipated or rather accommodated Lo’s hypothesis, Adaptive Markets has nonetheless done financial thought a great service. I has given it a coherent theory to broaden the EMH, to make it more realistic, and, in so doing, to give all a more comprehensive view of markets, in stable times and not. As for the practitioners, it offers a way to explain why their practical adjustments are necessary, why they work, and how they might cease to work at a future date. It is perhaps because of this valuable contribution that this reviewer was especially disappointed by one particular oversight.
When reviewing evolutionary theory, Lo shows how in periods of change, a species’ survival depends on a diversity of answers. These include the genetic mutations usually associated with evolutionary discussion, but also the formulation of new heuristics for a human community. If some go one way and others another, the odds rise that some part of the group or species will survive. A single answer for the whole community, if wrong, spells extinction. With this insight, evolutionary theory would seem to join the very different perspectives of Adam Smith, Friedrich Hayek, and others, when they argued the superiority of market diversity in meeting human needs and the danger of the singular and community-wide answers implicit in government direction. It would have made a welcome addition to the analysis had Lo developed this point. Sadly, he seems not to have even noticed its importance. Later in the book, he demonstrates that he missed it entirely when he suggests that the nation could guard against future financial crises with a kind of overarching regulatory body staffed by those proverbial disinterested experts. By turning away from his own support for market-based answers and embracing top-down direction Lo succumbs to what Hayek described as the “fatal conceit” of intellectuals.
Frustrating as this failure and some of Lo’s other quirks are, I must end where I began. This book makes a valuable and welcome contribution, rewarding the reader in so many ways by bringing science from diverse fields to broaden and improve our fundamental understanding of finance and markets.