Andrew Lo: Adaptive Markets Hypothesis Sheds Light on Crisis

The madness of mobs...

May 13, 2010

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1159376_74181875Andrew Lo puts his adaptive markets hypothesis in the context of the Financial Crisis in the latest issue of Journal of Portfolio Management. In an editorial called “Survival of the Richest” he writes:

The gut-wrenching financial events of the past two years have cast serious doubt on the traditional investment paradigm. The wisdom of diversification, the long only constraint, style investing, asset allocation, and the risk reward trade-off have all been challenged thanks to the rollercoaster ride of the S&P 500 in 2008 and 2009.But before we toss out our investments textbooks and delete our portfolio optimizers, we should reflect on the nature of their failures.

In The Wisdom of Crowds, James Surowiecki observed that collective decisions are most successful when the individual participants are diverse and independent—it is the aggregation of all those different opinions, perspectives, and bits of information that produces wise decisions. But when diversity and independence are replaced by conformity and herding, the wisdom of crowds can quickly become the “madness of mobs”—the Manhattan Project versus the lynch mob.

Even within each of us, recent neuroscientific research has shown that “rational” behavior is the outcome of a delicate balance among several distinct brain functions, including emotion, logical deliberation, and memory. If that balance is upset—say, by the strong stimulus of a life-threatening event— then reason is cast aside in favor of more instinctive reactions such as herding or the fight-or-flight response. And as social animals, humans will react en masse if the perceived threat is significant enough, occasionally culminating in riots, bank runs, and market crashes. Markets are not always efficient, nor are they always irrational—they are adaptive.

The adaptive markets hypothesis (AMH), which I first described in 2004 in this journal, provides an internally consistent framework in which the efficient market hypothesis (EMH) and bubbles and crashes can and do co-exist. During normal market conditions, the population of investors is heterogeneous, with diverse goals, information, and opinions— the wisdom of crowds. But during periods of market dislocation—when investors share the same goals (capital preservation), the same information (Lehman is failing and will not be bailed out), and the same opinions (the world is coming to an end!)—the madness of mobs can generate panic and crashes, in the same way that during periods of market elation madness generates bubbles.

Although still in its infancy, the AMH does offer several immediate implications for portfolio management. All investment strategies wax and wane to some degree, but beyond some threshold of assets under management alphas are transformed into betas. Portfolio diversification is still a good idea, but now much harder to obtain because of how quickly and competitively markets adapt. And because market volatility has become so volatile, asset allocation policies and passive investing must now be more dynamic and risk-sensitive.

Like the six blind monks who encountered an elephant for the first time—each monk grasping a different part of the beast and thus coming to a wholly different conclusion as to what an elephant is—the EMH and behavioral finance have captured different features of the same adaptive system. The traditional investment framework is not wrong, but merely incomplete. The sooner we adapt, the more likely we are to survive.

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