Adaptive Markets (2017) - Andrew W. Lo

Adaptive Markets (2017) discusses a fresh economic theory that enhances our comprehension of the human aspect influencing financial markets. Andrew W. Lo effectively demonstrates the limitations of existing dominant economic theories, highlighting that finance resembles a dynamic and developing organism rather than a rigid science like physics or mathematics – much like human behavior.

The Efficient Market Hypothesis (EMH) is widely recognized as the predominant theory explaining market behavior. Essentially, the EMH posits that stock, bond, and other investment asset prices consistently reflect a company's health, profitability, and overall value. While it is acknowledged that the EMH is not flawless, it remains highly esteemed by scholars and industry experts. An illustrative example of the EMH in practice is the case of Morton Thiokol, a company involved in NASA's space program in the 1980s. Following the Challenger Space Shuttle disaster in 1986, Morton Thiokol's stock value understandably plummeted due to the significant setback it faced. The EMH functions by incorporating the collective insights of investors who continuously evaluate and express their opinions on market conditions, thereby offering a relatively accurate valuation of companies. Given the EMH's credibility, the notion of "beating the market" is considered highly improbable, as it involves identifying overlooked opportunities. Consequently, the recommended approach is to "join the market" by investing in long-term, low-risk index funds or mutual funds, which consist of a diversified portfolio of stocks that are held over time. By adhering to index funds over an extended period, patient investors can capitalize on the stock market's gradual appreciation. These fundamental principles of the EMH inspired John Bogle to establish the Vanguard Index Trust, the first mutual fund, in 1976. Since then, the index and mutual fund industries have evolved into a multi-trillion-dollar cornerstone of the financial sector.

John Bogle introduced market cap weighted indexes to the Vanguard Index Trust in response to growing competition and as a means to reduce the workload for portfolio managers. Due to the decreased oversight needed for mutual funds utilizing this new feature, they are more cost-effective in terms of time and money, making them a more appealing option for investors. Considering market cap weighted indexes in an evolutionary context, it is not surprising that this feature is now prevalent in the majority of mutual funds today. This evolution can be attributed to competition, innovation, and natural selection within the framework of an efficient market.

Humans are predictably irrational when it comes to handling money.

One of the drawbacks of the Efficient Market Hypothesis is its assumption that rational investors will counterbalance the influence of irrational ones. Despite the acknowledgment that humans are prone to errors and flawed judgment, the key question remains: what impact can these behaviors have on the market? To begin with, it is crucial to comprehend the extent of human irrationality in risk-taking, probability assessment, and financial choices. Psychologists Daniel Kahneman and Amos Tversky have conducted insightful studies revealing the extent of our fallibility in high-risk financial decisions. Their research indicates that individuals are more focused on avoiding losses than on achieving gains, leading them to take greater risks to avert losses rather than to secure gains. This phenomenon, known as loss aversion, is a significant concept to bear in mind, as it greatly influences our financial inefficiency.

How severe can loss aversion become? Consider the case of Jérôme Kerviel, a junior trader at Société Générale. In 2008, Kerviel faced €4.9 billion in losses as a result of attempting to conceal minor losses through a series of reckless trading decisions. The psychological burden of loss aversion drove him to continuously escalate his risky behavior instead of cutting his losses promptly.

Another irrational tendency is known as probability matching, which occurs when we’re trying to predict what’s going to happen next. Let’s say we’re at a roulette wheel, and after watching the last few spins, we’ve noticed that red has been coming up more frequently than black; in fact, red has been coming up 75 percent of the time. Due to probability matching, most people’s instinct would be to bet on red 75 percent of the time. However, if the trend continued and the result was indeed red 75 percent of the time, and we only bet on red 75 percent of the time, our probability of winning would only be 62.5 percent – not such great chances after all. The smarter, but less human, choice would be to bet on red 100 percent of the time and win 75 percent of the time.

Emotions and instincts have a major impact on shaping human behavior, leading us to make impulsive and irrational choices, especially in financial matters. According to neuroscience, our decision-making processes are heavily influenced by the emotional part of our brain. For example, activities such as love, gambling, and cocaine can trigger the release of dopamine in our brain, creating a highly pleasurable and rewarding sensation. Research conducted by neurologists has demonstrated that dopamine plays a crucial role in driving individuals to take irrational risks. The gambling industry exploits this understanding by creating slot machines that sustain elevated dopamine levels, enticing gamblers to continue playing even when they are losing money. These machines are engineered to psychologically present a loss as nearly a win, which triggers dopamine release. As a result, even if a player narrowly misses the jackpot with one cherry, they experience greater pleasure than in a straightforward win/lose scenario. Engaging repeatedly in activities that stimulate dopamine release can lead to addictive behaviors and harmful habits. When faced with emotional situations involving dopamine, people are more prone to act impulsively rather than logically. This is a phenomenon that pilots must be trained to identify. In the event of an aircraft experiencing engine failure and descending, a pilot's natural instinct may be to pull up on the controls out of panic. However, this action would further decrease the plane's speed, reducing the likelihood of a safe landing. The correct response is to point the plane downward to gain speed before leveling out for a smooth landing. Due to the counterintuitive nature of this reaction, airline pilots undergo extensive training to override their innate instincts. In financial decision-making, individuals often make mistakes and incur avoidable losses when operating from a standpoint of fear and heightened emotional states like panic.

Similar to the concept of "survival of the fittest," the financial markets operate under the principle of "the survival of the richest." This shift is evident when examining the evolution of hedge funds, which were pioneered by Alfred Winslow Jones in 1949. Jones established the first hedge fund with $100,000, employing a strategy of investing in promising stocks while shorting weaker ones to hedge risks, hence the term "hedge fund." Despite the secrecy surrounding their methods, hedge funds quickly gained popularity and multiplied, showcasing the adaptive nature of the market. While some hedge funds fail due to poor decisions, successful ones thrive and new ones emerge annually, reflecting the ongoing process of natural selection in the financial landscape.

Some markets may experience prolonged downturns that exceed any reasonable investor's patience. For instance, after the crash in 1991, the Japanese market remained stagnant for two decades, known as the "lost decades." It is unrealistic to expect investors to endure such lengthy periods for equilibrium to be restored, which is why passivity is not always the optimal strategy. Instead, it is advisable to adapt to the evolving market conditions. For example, if a stock's price sharply drops due to irrational selling by a few investors, the efficient market theory would suggest ignoring this downturn, assuming the price will recover eventually. However, in certain cases like this, a "behavioral premium" can emerge. This occurs when irrational behavior becomes prevalent, leading more investors to sell and negatively impacting the company's long-term value. In such situations, relying solely on market efficiency would be imprudent. A more prudent approach would involve being dynamic and prepared to adjust investments according to changing circumstances. In the given scenario, this would entail selling shares that are losing value. Financial crises occur when market changes outpace the ability of investors to adapt, as adaptation typically takes place over extended periods.

The Adaptive Market Hypothesis has the potential to address more than just financial issues. By identifying the root causes of the 2008 crisis, it could guide us towards creating more stable markets. History demonstrates the necessity of robust legislation in safeguarding the economy from the detrimental impacts of greed and fear-driven decisions. Drawing a parallel with the investigation of the USAir Flight 405 crash in 1992, where the National Transportation Safety Board (NTSB) attributed the incident to systemic industry flaws rather than individual errors, underscores the importance of an impartial entity to scrutinize and recommend regulations. To prevent future financial turmoil, establishing a financial equivalent of the NTSB is crucial for analyzing existing challenges and formulating improved regulatory frameworks. The overarching goal for the industry should be to contribute positively to society, moving away from the negative associations of greed and self-interest. For instance, redirecting investment towards biomedicine, a field currently underfunded due to its perceived risks and delayed returns, could lead to groundbreaking advancements such as curing cancer within a generation. By creating a dedicated fund like "CancerCures," managed by experts and supported by public investors through bonds, similar to allied forces initiatives during World War II, numerous diversified research projects could significantly increase the chances of successful breakthroughs. This innovative approach could not only revolutionize cancer treatment but also pave the way for further transformative discoveries that benefit humanity as a whole.