Video Reports

Link to this video

Get LinkLicensePrint
Bookmark and Share

By Paul Kaplan | 10-23-2018

Evolving into better investors

As a science, finance is more akin to biology than physics, business professor says.

Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar Canada. Today, I'm talking to Andrew W. Lo who is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Business, writer of the provocative book Adaptive Markets - Financial Evolution at the Speed of Thought published by Princeton University Press in 2017.

Prof. Lo, thank you for talking to me today.

Andrew W. Lo: It's a pleasure.

Kaplan: Please briefly explain the adaptive markets hypothesis, or AMH.

Lo: Well, it's actually pretty simple. The idea is that financial markets behave more like a complex and evolving ecology rather than an immutable physical system. And so, when we start thinking about market dynamics, we ought to use the principles of evolutionary biology rather than mathematical laws of physics.

Kaplan: What are the implications of the AMH for investors?

Lo: Well, one of the implications is that periodically there are market opportunities that may look like inefficiencies from the traditional paradigm. Those inefficiencies -- in other words, profit opportunities -- they can last for a period of time, but eventually, they get competed away, because the market ecology is filled with all sorts of different species, some who are predators and others who are the prey. And so, this complex dynamic -- kind of a cat and mouse game -- happens all the time. And so, in order to be a good investor, one has to be wary of the environment that you are in and whether or not you are the predator, or you are the prey.

Kaplan: You wrote your first papers on the AMH back in 2004 and 2005. How were your ideas received by your fellow academics, by investment practitioners?

Lo: Well, it's interesting. There are two very different receptions as you can imagine. From the academic community, naturally, there was a certain amount of inertia in terms of the status quo. So, I would say that probably a lot of skepticism at first. And little by little, I think, we are making headway in the academic community, particularly because of the financial crisis and all of the various different consequences for our various different financial theories. But where the ideas got the most traction, right away, was from the practitioner community. Anybody who has ever tried to manage money for a living, understands that markets are not always perfectly efficient, but at the same time, the efficient markets hypothesis is a great approximation in many cases, and one has to keep it in mind as thinking about all the various different opportunities that are out there.

Kaplan: How did you develop the AMH? Did the ideas come to you gradually or was there an epiphany?

Lo: Well, I guess, a little of both. I had been thinking about these ideas for quite some time. As an assistant professor and even before in grad school I had been thinking about ways of testing market efficiency and trying to understand whether or not stock markets are predictable to some degree. And so, early on I came up with a number of tests that suggested that, well, there may be some predictabilities in the marketplace. But at the same time, I knew that it wasn't easy to make money. There are people who are successful at it. A number of hedge fund managers over the years have put together impressive track records. But at the end of the day, it wasn't easy for any person to be able to do that. And so, that got me to start thinking about the fact that markets really are much more like a competitive process that evolves over time.

The epiphany actually occurred when I was at the zoo in Washington DC with my then only child and now my older son, but at that time we only had one child, he was about 5 or 6 years old. And he wanted to go see the great apes. And so, we took him to the ape house. And we were standing by the cage, looking at the great ape and it looked like there was a little baby ape right next to her. And my son went a little bit too close to the cage and immediately the mother ape interposed herself between the bars and my son. And we got scared. And as soon as I saw that, I ran away and grabbed my son and pulled him back. And at that moment I realized that what I was doing was actually not that different from what that great ape was doing. We were basically protecting our young. And it occurred to me then that humans are just another species of animals. We have certain amazing features like the brain, being able to think about various different ideas abstractly. But at the end of the day, we are also hard-wired in many ways like other mammals. And it's that hard-wiring that periodically causes us to behave in ways that are less than rational.

Kaplan: In reading your papers and your book, I developed six key takeaways. Please comment on each one. Economics and finance should be based on evolutionary biology and not try to mimic physics.

Lo: Yeah. I think that the physics envy that I write about is something that I myself suffer from. We would all love to be able to have three laws that explain 99% of all human behaviour. Instead, I think, economists have 99 laws that maybe explain only 3% of behaviour, and it's very frustrating for us that state of affairs. And the final realization came to me that in fact the physical systems that we are used to really don't hold when we are dealing with human behaviour, and we have to think about much messier systems like those that ecologists and evolutionary biologists study all the time.

Kaplan: Many of the behaviours that behavioral economists describe as being irrational are maladaptive.

Lo: Yeah. It's very easy to point fingers and say human behaviour has all of these flaws that are not ideally suited for financial decision-making. I would argue, of course, it's not. Financial markets have only been around for at most a couple of thousand years whereas human evolution has taken place across a number of different species over millions of years. And so, you wouldn't expect that we would be ideally suited to engage in financial transactions and financial decision-making because that's a relatively new phenomenon of our environment. And so, if we take a look at it from that perspective, it's a lot easier for us to understand why we engage in so many of these irrational behaviours. It's because much of our hard-wiring was developed from the Neolithic ice age when financial markets didn't really exist. So, we need to start thinking about developing other better tools to prevent us from making the kinds of mistakes that our human evolution makes us more prone to than otherwise.

Kaplan: Reason and emotion are not in opposition but rather go together.

Lo: Yeah, that's a very interesting proposition that really came to me from the neuroscience literature. I was actually surprised to learn that certain kinds of patients of neurosurgery outcomes that ultimately ended up becoming very irrational. They were irrational because they did not have the capacity to feel. So, for example, a brain tumour patient that has the part of his emotional brain removed and can't actually feel has actually no interest in getting tasks done because in order to get a task done, you have to feel nervousness, anxiety, you have to fear the consequences of your boss asking you why you are half-an-hour late to work. And the kind of fear, anxiety, nervousness, elation when you succeed in a task; if you eliminate all of those things, you actually eliminate a lot of what we consider to be rational decision-making. So, that was a real insight that Antonio Damasio was the first to come up with in his book Descartes' Error, the fact that emotion and rational decision-making are opposite sides of the same coin.

Kaplan: Capital markets are analogous to ecosystems.

Lo: Well, mainly that if we want to understand how financial markets work, then we actually have to start behaving like ecologists instead of physicists. In other words, when we study a particular market, instead of trying to write down the fundamental laws of pricing for those markets, we ought to behave like an ecologist studying a new ecosystem for the very first time, and that means going out and doing field experiments, collecting data, doing a catalog of all the different species, all of the different predator-prey relationship, the particular environment, the sources of food, the biomass of the various different species. Until we start collecting data the way that a biologist would, we are probably not going to be able to get the same kind of insights we need in order to make more accurate predictions.

Kaplan: The AMH reconciles the efficient markets hypothesis and behavioural finance.

Lo: That's a very important point that I can't stress enough. When I first wrote the book a number of people said, wow, you are awfully brave to take on the efficient markets hypothesis and try to trash it. On the contrary, I actually think that the efficient markets hypothesis is one of the most important ideas in all of social science, and the reason I wrote the book is because far too many people were willing to trash it without an alternative, without understanding that in fact the efficient markets hypothesis works well a lot of the time. It's not wrong. It's simply incomplete in that it doesn't capture the entirety of human behaviour. And so, rather than talking about whether it's right or wrong, a more productive approach should be, let's ask when it holds and when other alternatives become more important. So, I actually think that work on adaptive markets suggests that efficient markets have a very complex and important dynamic with some of the behavioural alternatives that we see in the literature.

Kaplan: As it says in the title of your book, financial evolution occurs at the speed of thought.

Lo: Well, that's a really different perspective that I think most people have not thought about simply because they haven't had any occasion to. The way that evolution works in practice is one generation at a time, and some would argue it occurs at the level of the gene. So, The Selfish Gene By Richard Dawkins is the best example of this particular perspective. But it turns out that humans have an ability that as far as we know is unique to our species. Which is that we can affect change not one gene at a time, not one generation at a time, but rather one idea at a time. We have the ability to think in abstract terms. So, if I'm trying to build a better mousetrap, I can actually imagine a thousand different designs for a mousetrap and in my brain or in my computer, I can simulate the mousetraps that work and don't work and pick the best of those thousand different designs. Before I ever put a handsaw to a piece of wood to start building the mousetrap, I have actually gone through a thousand iterations of evolution. That's one of the reasons that homo sapiens have now dominated the planet and we have populated virtually every ecosystem there is on this planet. It's because that we are able to engage in evolution not at the speed of procreation and reproduction, but at the very speed of thought.

Kaplan: Is there anything that you'd like to add?

Lo: Well, I guess, the only other thing I would add is that one of the principles of the adaptive markets hypothesis is that the only constant is change and that what we have to focus on is our environment and how that environment is changing because ultimately that will tell us how humans are adapting to the challenges that we face. If we focus too much on the so-called fundamental principles of economics or finance, the laws of motion that people are supposed to engage in, we may end up missing the forest for the trees. We may not see that the environment's shifting is a far more important determinant of human behaviour than our own deep parameters or preferences.

Kaplan: Thank you, Prof. Lo for taking the time today to discuss Adaptive Markets - Financial Evolution at the Speed of Thought.

Lo: Thank you. It's been a pleasure.

{1}
{1}
{2}