Despite Lo’s credentials as a professor of finance at MIT, the audience for this book is the moderately well-read layman. Lo begins with basic lessons in economics detailing the efficient market hypothesis that would bore most economists. From there he recounts behavioral biases that would be familiar to anyone versed in the psychological work of Daniel Kahneman. Next, Lo gives a primer on genetics and evolution that would be old hat to anyone who remembers his Darwin. He also touches on points of neurobiology that describe the mainstream accounts of what bodily actions the amygdala and prefrontal cortex “control” in the brain. Lo summarizes each of these fields adequately, but almost two hundred pages into the book we have nothing of original insights. Lo’s effort is to synthesize these fields into his own new theory of financial markets. As he points out over and over again, “it takes a theory to beat a theory.” The book flows smoothly and Lo is a great storyteller. His skill is in explaining concepts in ways that are easy to understand. This should not be undervalued.
One of the main thrusts of Lo’s argument is that financial markets exhibit more properties common to biology than physics. Despite post-WWII economics having derived many of its methods from Paul Samuelson, who was primarily inspired by mathematical physics, the proper way to see how financial markets behave is by looking to parallels in evolutionary biology and how evolution has shaped the behavior of men. "The Adaptive Markets Hypothesis puts a much greater weight on past environments and adaptations to explain market behavior, and like Darwin's theory before it and Farmer's ecosystem of trading strategies, the Adaptive Markets Hypothesis doesn't predict any trend or end-state as inevitable.” Lo uses his adaptive market theory to analyze the financial crisis of 2008 and the market events that led up to that event.
Humans are adapted to learn from their past experiences. Therefore, after prolonged periods in the absence of accidents, we tend to push the boundaries of risk. Memories of the last catastrophe recede from the collective memory. Those who urge caution are shunted aside, labeled as pessimistic bears, while those taking greater and greater risks reap greater and greater gains. No one wants to be the one to first stop dancing while the music is still playing. The Great Moderation, between the mid-1980s and the financial crisis of 2008, was such a period. Market volatility decreased. Quantitive analysis enabled funds to use mathematical models to squeeze gains from the market. No one wanted to be the sucker playing it safe. By taking on more and more leverage financial firms could generate even greater profits. Unfortunately, many of these highly leveraged investment banks, hedge funds, and insurance providers were also wedded to similar strategies. After all, while the market remained relatively static, the winning strategy generated the greatest returns. Once the formula was found out, more leverage was the only way to keep maintaining profits at previous rates. This also created systemic risk. Hyman Minsky predicted that after such bouts of confidence in ever-rising financial values, over-confidence and an under-appreciation of risk were bound to ensue, resulting in a system-wide catastrophe. Greg Ip would call this a failure to be “fool proof”. Relative safety in the short term breeds excessive risk taking, lack of pruning along the edges, and, therefore, a massive failure later on down the line. All these firms were adapted to a stationary environment and when the market fundamentals shifted they did not foresee change fast enough and so could not adapt to the new financial landscape. “When conditions change, our fallible human heuristics use our old adaptations to respond to unexpected events.” Markets freeze, there is a flight to quality, and even safe assets are viewed with skepticism. The madness of the mobs replaces the efficient market.
Lo relates that all the actors involved (from bankers, to insurers, to realtors, to regulators, to politicians) were acting in ways that humans were “trained to” from an evolutionary perspective. Unfortunately, in the current environment with quant trades every millisecond and derivatives of increasing complexity, biological evolution is too slow to adapt to financial changes. Human cultural platforms are evolving faster than biology could keep up. Our heuristics serve us well in normal times. But when confronted with a rapidly changing arena and a disaster that had never happened before and was hard to predict (quantified as a twenty-five sigma event by Goldman Sachs), markets froze up and no longer behaved rationally or efficiently. Lo ends by stressing that it was not individuals but the system that failed. Only by changing the incentives, reducing moral hazard, and lowering the gains as well as the losses, can the market be steered in a fashion as to mitigate future market failures by reducing excessive risk.
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