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A**N
Excellent new idea on the evolutionary nature of financial markets and the unlikely case of general equilibrium in steady state
Adaptive Markets is an excellent book on the nature of markets and economics as a field broadly. There is a lot of content in the book and it starts from first principles and discusses comprehensively the field of financial economics and where it stands today. The author brings his originality in thinking about the nature of markets and people to the general audience with a lucid discussion of both behavioral and mathematical finance and both of their merits and failures. The author describes how markets are evolutionary in nature and the background market place does not exist in a vacuum and this evolutionary nature is why markets can be both efficient in a particular regime but fragile to a change in regime. There is much to think about in reading this book but it is well worth the effort.The book is split into 12 chapters and include a lot of material and ideas. To set the stage the author gives the philosophical background of most modern economists which have followed in the footsteps of Paul Samuelson who helped mathematize economics. The base assumption of financial economists are that people act rationally and their decisions are constant manifestations of the attempt to maximize their utility. The author discusses some of the implications of this, in particular the game theory associated with common knowledge as well as some impressive example of when markets lead to remarkably quick processing of events and their implications on value changes in equity prices. The author spends time discussing behavioral finance and things like loss aversion and the importance of framing questions. The author gives case studies of where behavior looks irrational from an expectation maximization perspective. In particular he discusses how people use probability matching as a default heuristic for most people when making bets, say in a game where you get paid on heads and pay on tails and the odds of heads are 3/4 to 1/4 people make bets in relative frequency of 3/4 heads, 1/4 tails rather than 100% heads despite the superiority of such a strategy. The author also discusses some of the biological consequences of gambling and trading. As we can now monitor physiological changes as a consequence of realizing gains and losses for professional investors and traders, the results show that our emotional states are affected by dealing with gains and losses and certain people have trained themselves to deal with this better but the idea that we calculate odds equivalently in all mental states is empirically false. The author discusses results from neuroscience and results from split brain research. One key result is how our minds create narratives to make sense of the world and successful prediction depends on how one creates narratives that frame cause and effect in the world we live in. As a final background chapter the author discusses principles of evolution and the scientific record of man as well as on how brain structure evolved. The book is filled with results that help frame both ideas from behavioral finance as well as from traditional efficient market financial economics.The author moves from the background information to the core of his fresh ideas which he calls the adaptive market hypothesis. The author reminds the reader that despite the clear failures of people to live up to the ideal calculation agent that is homo economicus, academic fields require a new theory before discarding an old one. Describing counterexamples to assumed behavior just isn't good enough. The adaptive market hypothesis is, among many things, the idea that people develop heuristics to the market environment that are successful, but that the environment in which those heuristics are effective is always changing both due to the behavior of individuals changing as well as to exogenous factors. The author highlights how matching probabilities is a successful strategy in which the population is trying to maximize its size in an environment which changes state unpredictably even though such a strategy does not maximize the individuals survival. The author discusses how efficient markets and adaptive markets fundamentally differ in that adaptive markets don't have a general equilibrium. They might have a local equilibrium where that equilibrium is dependent on nothing changing but the world is always changing so behavior and what is right and wrong as a strategy is always adapting. It is a very compelling idea, that what drives markets and what is a successful strategy in markets is always changing as the landscape is evolutionary and adaptation is immediate rather than generational as knowledge is transferred at the speed of thought.The author uses hedge funds to highlight the evolutionary nature of markets describing how varying strategies can be effective and that strategies which were successful no longer need be. The author also discusses the results of his analysis of the quant meltdown in 2007 which is very interesting as he charts the profit and loss function from mean reversion trading and its huge change in outcome during the summer. The author highlights how certain things can self reinforce one another but are then very fragile to regime shift. The author spends time on discussing the fact that markets don't exist in isolation and that the ethics of markets can be dependent on their structure so that setting up markets correctly can impact the social outcomes. The author spends some time as well on some partial solutions to finance today and how markets are remarkable systems that can solve problems when properly applied. The author discusses global warming, longevity, poverty and how finance could be used to solved with appropriate funding solutions that diversified risks.Adaptive markets puts a lot of material together to form a theory of markets as an evolutionary social construction. It uses the ideas from efficient markets, behavioral finance, neuroscience, evolutionary biology and evolutionary game theory to frame how to view the reality of investing in financial markets. A lot of the background material lies elsewhere and the author cites these authors and books but the work is self contained despite the broad base of subjects included. I definitely think this is a work of very high quality from a very well respected academic. There are small parts which meander a bit but the author weaves the subjects together to give a coherent overview of a complex subject and frames his thesis and evidence well. Highly recommend.
A**N
Geek heaven
Andrew Lo specializes in derivatives. What he does not know about them is really not worth knowing. Funny thing is, there isn’t one sentence in this book about derivatives. A very highly-regarded author and academic has written a book about the physiology of fear, the experiments of Danny Kahneman, the chemistry of pleasure, Charles Darwin, quantum mechanics, but not his subject of expertise.How come?Once upon a time, many good (and other not-so-good) people believed that the role of derivatives was to “complete the market.” So, for example, if you “short” the stock of a company via a put option, by construction a feature is built into that put option that in the market is called a “stop-loss:” You cannot possibly lose more than the “premium” you paid to buy the put. A guy who borrowed the stock and sold it on margin can in theory lose an infinite amount of money if the trade goes against him. You can’t.Such a “stop loss” does not grow on trees. It does not exist in nature. So this is a way in which a put option “completes” the market for trading in the stock of this company. You can now gain negative exposure to the stock of this company in a manner that was previously not available. If the market in the stock of this company gaps up (for example, doubles) without trading the prices in between at which it would have been necessary to buy the stock back to enforce a “stop-loss,” that is somebody else’s problem. Not yours.That is but one example of many where derivatives “complete markets.”People like Andrew Lo spend their time as academics examining, understanding and explaining to others how these constructs work.Sadly, while derivatives do indeed complete markets, that’s not at all how we use them. Derivatives, 99.9% of the time are entered into by end-users for much more prosaic reasons. A poor guy who cannot borrow money can use them to obtain otherwise unobtainable leverage. A fund manager in Orange County who fancies himself the next George Soros can use them to circumvent his mandate. A country like Greece can use them to legally move its debt “off balance sheet” to meet the Maastricht criteria. An investment bank like Goldman Sachs can buy them from other counterparties of AIG to hedge against the potential demise of… AIG. (Sorted!) And so forth.Which leaves academics that study derivatives in a funny place. They teach PhD’s about derivatives and then these guys, clutching their diplomas, mostly go to work in “risk,” a function within a financial institution whose chief role is to devise excuses for why whatever trade the boss wants to do fits within his mandate. Or alternatively, they function as the “fall guys” if something goes wrong, because their job description was to rubber-stamp whatever strategies or procedures went wrong.This does not mean financial economists know nothing. They know a whole lot. And they come in contact with loads of movers and shakers. And at least they understand deeply, at the formula level, the mechanics of the instruments that are causing many of our problems in finance today. It’s just that finance theory, per se, is at right angles to the solution of our problems, precisely because finance is not practiced in the way that is predicted by finance theory.To put it differently, if I use a thousand dollar fountain pen to stir my coffee, the senior engineer at Montblanc may not be a guy with knowledge relevant to my life. If everybody uses his thousand dollar fountain pen only to stir his coffee, the senior engineer at Montblanc is entirely surplus to requirements. Except, of course, if he’s friends with all the guys who buy his pens, knows their stories and can tell you how they all go about stirring their coffee (assuming you care to know).And that’s what we’ve got here:Hot on the heels of Richard Bookstaber’s “The End of Theory,” (whose previous book, incidentally, he trashes by implying its “high complexity” and “tight coupling” theory is cribbed from a 1984 book by an author called Charles Perrow), Andrew Lo has written a book that not only1. explains that there is no such thing as a “homo economicus” who always correctly and rationally computes the best course of action for his economic life, but also2. proposes an alternative way to explain the worldThe fundamental insight is that economic agents (you and I) are driven by behavior that is pre-programmed into us by evolution. Andrew Lo’s conclusion is that this behavior must by nature be adaptive, because that is the type of behavior that evolution rewards. That is the “Adaptive Markets Hypothsis.”The author does not get there fast. What we have here is a tremendously entertaining, witty, often wordy, but never boring tour of the natural sciences and how the author thinks they pertain to man’s attitude to risk and uncertainty.Does it add up?For me, it doesn’t.I’ve spent 25 years trading, for a good 8 or 9 institutions and I promise you that if anybody thinks past year-end he will trade in a manner that will get him fired. Hell, you probably should not think past month-end if it’s a career in finance you want. How on earth that individual behavior somehow conspires to add up to collective behavior that becomes adaptive, and how anybody can think that when all we observe around us is stuff like Bitcoin trading at 2000 is beyond me.I guess Andrew Lo is saying we should behave adaptively. But the observation that when things are calm homo economicus is a good model and when all the little pockets of value have been arbed all bets are off is resolutely not the same as saying the adaptive model is the one that should guide a market observer in the small. Rather, you need to do what Chuck Prince said and dance when the music is playing. I would contend that Warren Buffet is doing no different, but has the deep pockets and corporate structure to not get killed when the dance floor gets slippery…And yet, for me “Adaptive Markets” was pure entertainment. If the book was 800 pages rather than 400 I would have read it anyway, because I had a super time reading it. There are tons of fun things here that have nothing to do with markets, but were a joy to read and think about. Like, I finally found out what “New Math” was and I’ll order the books for my kids. Or there is a treatise on what it means to be intelligent (Andrew Lo’s answer: the ability to put together good narratives) Stuff like that, which I totally loved.There’s also some annoying stuff for geeks like me. For instance, despite explaining toward the end of the book exactly how positive feedback can get a microphone to squeal, the author does a solid impression of an HR lady at the beginning of the book when he keeps discussing “positive feedback” and “negative feedback” in the context of how people answer surveys. Sloppy.So that’s really it. A hyper-wordy book, a whirlwind tour of all departments at MIT, I guess, from sociology to psychology to neurobiology, with stops to take pictures of the 2007 quant meltdown and the 2010 flash crash, best exemplified by the rather facile explanation of prospect theory (it’s because of the amygdala, who is not a character in Star Wars, read the book to get the scoop), but a tremendous read if you are a nerdy guy like I am.If, unlike me, you are not a dweeb, you should probably skip, though.
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