Andrew Lo’s theory of how economic actors mimic ecological ones
Adaptive Markets: Financial Evolution at the Speed of Thought. By Andrew Lo. Princeton; 483 pages; $37.50 and £31.95.
ECONOMISTS have been accused of “physics envy”, an obsession with constructing precise mathematical models instead of studying the real, messy, world. But a new book suggests that economists have been looking at the wrong science; they should have focused on biology.
The idea stems from the school of “behavioural economics” which observes that humans are not the kind of hyper-rational calculating machines that some models rely on them to be. As a result, markets are not always “efficient”—accurately pricing all the available information.
When Andrew Lo was a young academic, he presented a paper at a conference which showed that one of the key assumptions of the efficient market hypothesis was not borne out by the data. He was instantly told that he must have made a programming error; his results could not possibly be right.
Mr Lo, who is now a professor at MIT, has spent much of his career battling to steer economics away from such narrow-minded thinking. His grand idea is the “adaptive markets hypothesis”. The actions of individuals are driven by intellectual short cuts—rules of thumb that they use to make decisions. If those decisions turn out badly, they adapt their behaviour and come up with a new rule to follow.
The theory is bolstered by experiments that show how humans make decisions. Psychological quirks include an unwillingness to take losses and a tendency to make patterns out of random data. These traits may once have been useful in evolutionary terms (that rustle in the bushes might not be a predator, but better safe than sorry) but are less helpful when making financial decisions.
Research has also shown what happens inside our brains when we make decisions. Winning money has the same effect on a brain as a cocaine addict getting a fix, while losing money has the same effect on risk-averse people as a nasty smell or pictures of bodily mutilation. Furthermore, it seems that emotion plays a significant part in gauging risks, and not always a negative one, acting as a “reward-and-punishment system that allows the brain to select an advantageous behaviour”. If we do not fear the consequences of failure, we may act irresponsibly, just as small children need to learn to be wary of cars before crossing the road. Studies of people with brain damage show that “when the ability to experience emotions is removed, human behaviour becomes less rational.”
When we apply our behavioural quirks to the markets, the result is a kind of fast-track evolution in which investment strategies are tested in a fast-changing environment. Mr Lo describes the hedge-fund industry as the “Galapagos islands of finance”; many thousands have been set up but the extinction rate is very high.
The theory may also explain why the economy can see long periods of stability followed by sudden crisis. Mr Lo writes that “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.”
The same process of adaptation occurs between the finance industry and its regulators, with the regulators always one evolutionary step behind the regulated. One answer, suggests Mr Lo, is to create a financial equivalent of America’s National Transportation Safety Board (NTSB). Because the NTSB is not itself a regulator, it feels able to criticise both transport companies and regulations; that makes its conclusions genuinely independent.
Mr Lo makes a convincing argument and he also uses the book to lay out some interesting ideas—such as a huge, diversified fund that would invest in a range of potential cancer treatments. But while readers may nod their heads in agreement with the author, it is not clear what they should do next. The adaptive-markets theory does not really produce any testable propositions, or market-beating strategies. And regulators might benefit from his suggestions on monitoring financial risk but might still struggle to know what to do in response. Perhaps that is the point; evolution doesn’t have an end game in mind.
This article appeared in the Culture section of the print edition under the headline "Evolving ideas"
