Half of all Americans have money in the stock market, yet economists can't agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe'and as financial bubbles, crashes, and crises suggest. This is one of the biggest debates in economics and the value or futility of investment management and financial regulation hang on the outcome. In this groundbreaking book, Andrew Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist.
Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, Adaptive Markets shows that the theory of market efficiency isn't wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit. Lo's new paradigm explains how financial evolution shapes behavior and markets at the speed of thought'a fact revealed by swings between stability and crisis, profit and loss, and innovation and regulation.
A fascinating intellectual journey filled with compelling stories, Adaptive Markets starts with the origins of market efficiency and its failures, turns to the foundations of investor behavior, and concludes with practical implications'including how hedge funds have become the Galápagos Islands of finance, what really happened in the 2008 meltdown, and how we might avoid future crises.
An ambitious new answer to fundamental questions in economics, Adaptive Markets is essential reading for anyone who wants to know how markets really work.
Introduction 1
Financial Fear Factor 1
Don't Try This At Home 4
The Great Divide 6
"It's the environment, stupid!" 8
Revenge of the Nerds 10
1 Are We All Homo economicus Now? 12
Tragedy and the Wisdom of Crowds 12
A Random Walk through History 16
The Birth of Efficient Markets 20
Efficient Markets Unpacked 25
What to Expect When You're Expecting 28
Efficient Markets in Action 38
2 If You're So Smart, Why Aren't You Rich? 45
Rejecting the Random Walk 45
Risk versus Uncertainty and the Ellsberg Paradox 51
Losing Hurts More than Winning Feels Good 56
No-Limit Texas Hold 'em, Rogue Traders, and Regulators 59
Probability Matching and March Madness 62
Humans as Prediction Machines 65
It Takes a Theory to Beat a Theory 69
Culture Shock 71
3 If You're So Rich, Why Aren't You Smart? 75
Looking under the Hood 75
The Microscope of Neuroscience 76
Fear 78
Pain 85
Pleasure and Greed 87
Wired-Up Traders 92
The Stuff Good Traders Are Made Of 94
Mind over Money via Neural Currency 96
I Want It All, and I Want It Now 98
4 The Power of Narrative 102
A New Meaning of Rationality 102
The Human Fire Alarm and Sprinkler System 104
The Fear Factor and Finance 106
I Know You Know That I Know 108
Homo economicus and the Left Hemisphere 113
The Prefrontal Cortex as CEO 117
The Power of Self-Fulfilling Prophecies 123
Barbara Ficalora, the Best Third Grade Teacher Ever 124
Narrative Is Intelligence 128
5 The Evolution Revolution 135
A Day at the Zoo 135
The Evolution Revolution 136
Just-So Stories or Scientific Fact? 138
The Power of Selection 141
Variety Is the Spice of Life 144
"It's the environment, stupid!" 146
The Emergence of Homo sapiens 150
Enter Homo economicus 152
An Evolutionary Pecking Order 156
Swedish Twins and Savings 158
Evolution at the Speed of Thought 162
Sociobiology and Evolutionary Psychology 168
Survival of the Richest? 175
6 The Adaptive Markets Hypothesis 176
It Takes a Theory to Beat a Theory 176
Simon Says Satisfice 177
The Superman Jacket 182
The Adaptive Markets Hypothesis 185
Probability Matching Explained 189
Nature Abhors an Undiversified Bet 195
"It's the environment, stupid!" All Over Again 196
Homo economicus and Idiosyncratic Risk 198
The Origin of Risk Aversion 203
Efficient versus Adaptive Markets 206
Waylaid by Physics Envy 208
On the Shoulders of Giants 214
7 The Galapagos Islands of Finance 222
Quantum Mechanics 222
Mission Impossible 224
The Islands of Evolution 225
Hedge Fund Archipelago 227
An Evolutionary History of the Hedge Fund 231
The Birth of Quants 235
The Revenge of the Nerds 236
Quant Goes Mainstream 240
The Evolution of the Random Walk 244
Cell Phones and Kerala Fishermen 246
8 Adaptive Markets in Action 249
The Traditional Investment Paradigm 249
The Great Modulation 254
A New World Order 256
Risk/Reward and Punishment 258
The Democratization of Investing 263
New Species of Index Funds 265
Smart Beta versus Dumb Sigma 267
Disbanding the Alpha Beta Sigma Fraternity 271
The Random Walk Revisited 277
A New Investment Paradigm 282
The Quant Meltdown of August 2007 283
Forensic Finance 284
Adaptive Markets and Liquidity Spirals 289
1998 versus 2007 292
9 Fear, Greed, and Financial Crisis 296
Ecosystem Ecology 296
Financial Crisis 101 298
Clear as Rashomon 301
Not Enough Skin in the Game? 303
Regulators Asleep at the Wheel? 306
Red Pill or Blue Pill? 312
Could We Have Avoided the Crisis? 314
The Adaptive Markets Hypothesis Explains 318
(Ab)Normal Accidents 320
Liquidity Withdrawal Symptoms 324
10 Finance Behaving Badly 330
Finance Rules 330
Out-Ponzi-ing Ponzi 332
The Ultimatum Game 335
A Neuroscience of Morality? 338
Is Finance Fair? 340
Finance and the Gordon Gekko Effect 345
Regulatory Culture 349
Environment Strikes Again 352
Moore's Law versus Murphy's Law 355
The Tyranny of Complexity 361
11 Fixing Finance 365
An Ounce of Prevention 365
Ecosystem Management 366
Adaptive Regulation 368
Law Is Code 371
Mapping Financial Networks 375
The CSI of Crises 378
Privacy with Transparency 384
Anti-Gekko Therapies 387
12 To Boldly Go Where No Financier
Has Gone Before 395
Star Trek Finance 395
"Computer, manage my portfolio!" 397
Curing Cancer 400
Eliminating Poverty 411
A New Narrative 415
I Want To Be Harvey Lodish 418
Notes 421
References 439
Acknowledgments 463
Index 469
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