Since Paul Samuelson published his classic work "Foundations of Economic Analysis" in 1947, academic economists have been afflicted with "physics envy," Andrew Lo writes in his new book "Adaptive Markets: Financial Evolution at the Speed of Thought."
Samuelson was "the single most important economist of the 20th century," Lo writes, and "found his inspiration in modern mathematical physics." That preference shaped economic research for decades to come, including the flood of scholarship written to bolster the efficient markets hypothesis, which holds that stock prices incorporate all available information.
But the work of Daniel Kahneman and Amos Tversky and the behavioral economists whom they inspired challenged the efficient markets paradigm with research that showed how irrationally even supposedly clear-minded investors behave.
Lo, a professor at MIT's Sloan School of Management and director of the MIT Laboratory for Financial Engineering, follows in that tradition with "Adaptive Markets" where he proposes a theory of market behavior that stems from evolutionary theory and environmental biology. The financial markets are a constantly changing ecosystem in which participants either adapt their thinking to current conditions or fail.
It's an engaging if not entirely satisfying work, much of which will be familiar to readers of the popular literature on Kahneman, Tversky and their followers. Lo does glean insights from his study of hedge funds, which he calls the "Galapagos Islands of finance" because of the rapid pace of innovation—or evolution, to continue the biological metaphor—that they require of participants, just as species on the Galapagos evolved in distinctive ways because of their isolation.
Lo is particularly strong on the August 2007 stock market meltdown that presaged the next year's financial crisis. Engaging in what he calls "forensic finance," Lo observes that quantitative hedge funds suffered especially steep loses. He and a graduate student backtested a simple investment strategy in which a hypothetical hedge fund shorted the previous day's winners and bought the losers, an approach that resulted in a 25% loss over three days.
Central bankers then pumped billions of dollars into the global banking system and stocks recovered. The losses showed the increased systemic risk in the financial system because of the significant increase in the number of quant funds and the rise of funds that invest in other hedge funds. An investment strategy had proven successful and attracted numerous adherents whose very entrance into the market causes a major correction.
Lo believes that the the August 2007 mini-crash may stemmed from a forced liquidation of stock and hedge fund positions by an entity, perhaps a commercial bank, that needed to raise cash quickly because of margin calls on a mortgage- and credit-related positions, but he emphasizes that his "inferences are necessarily indirect and tentative."
Such indeterminacy also characterizes Lo's theory, which nonetheless seems more realistic than the efficient market hypothesis and thus more useful as a framework for understanding financial markets.