Monday, September 8, 2008

Andrew Lo's hypothesis

Lo calls his view the "adaptive markets hypothesis." Note the modesty of the term "hypothesis" rather than the more declamatory "theory."

Anyway, the AMH stems from a new interpretation of the fall of Long-Term Capital Management. LTCM's spread positions were "quite rational," Lo writes. They were impossible to maintain, though, because "the forces of irrationality -- investors flocking to safety and liquidity in the aftermath of the Russian default in August 1998 -- were stronger, at least for several months, than the forces of rationality."

That's a rather sharp contrast with the views that, for example, Roger Lowenstein expressed in his book on LTCM.

Anyway,Lo's view is that their "spread positions were quite rational," but that the markets stayed irrational longer than they could stay solvent.

We can understand the actual balance of rationality and irrationality, Lo thinks, if we begin with the idea that there are distinct species within the ecosystem of the market. Each species has its own ecological niche.

When circumstances change, when a shoreline moves or the climate warms up, the old niche may become maladaptive. The deck gets re-shuffled, not immediately but over time.

Likewise, when something happens to change an economic/financial environment, previously rational strategies may become maladaptive.

Lo writes, "Individuals make choices based on past experience and their best guess as to what might be optimal, and they learn by receiving positive or negative
reinforcement from the outcomes. If they receive no such reinforcement, they do not learn. In this fashion, individuals develop heuristics to solve various economic challenges, and as long as those challenges remain stable, the heuristics
will eventually adapt to yield approximately optimal solutions to them."

Each individual's "heuristic," then, or investment strategy, will be path-dependent. It will be what it is because of the history of the crises that individual or institution has experienced. The different species that have their origin in such means include: pension funds; hedge funds, retail investors, and market makers.

I'll finish the thought tomorrow.

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