Andrew Lo's hypothesis: conclusion

So if we've followed Lo's reasoning set out in yesterday's entry, we have a sense of how different species emerge. Speciation depends upon changes in economic conditions that change the adaptive behaviors into maladaptive ones, and force a re-jiggering. The specifics of the re-jiggering lead to distinct roles, or ecological niches, explaining the distinctions between hedge fund behavior and pensiuon fund behavior.

"The AMH is still under development.... Even at this early stage, though,
it seems clear that an evolutionary framework is able to reconcile many of the apparent contradictions between efficient markets and behavioral exceptions. The former may be viewed as the steady-state limit of a population with constant environmental conditions, and the latter involves specific adaptations of certain
groups that may or may not persist, depending on the particular evolutionary paths that the economy experiences."

Presumably, of a "steady state" stayed steady long enough, the different species might all mongrelize back into one another. In that respect, Lo's speciation is different from Darwin's. But that is a trivial point, because the steady state is only a theoretical "limit," -- change is the reliable reality. Species remain distinct.

One of the implications of the view is: "[I]nvestment strategies will also
wax and wane, performing well in certain environments and performing poorly in other environments. Contrary to the classical EMH in which arbitrage opportunities are competed away, eventually eliminating the profitability of the strategy designed to exploit the arbitrage, the AMH implies that such strategies may decline for a time, and then return to profitability when environmental conditions become more
conducive to such trades."

And that is where I will leave the matter for now.

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.

Not in real time

I'm traveling, dear reader, so for the next few posts on this website you'll be reading material I prepared weeks ago and scheduled for these dates.

Hope you enjoy it nonetheless.

To dive in, here's a link to a fascinating paper by Andrew Lo, a professor at MIT.

Lo is discussing the efficient market hypothesis, which (a) seems to have a powerful logic to it, but (b) runs into important counter-examples in the world of fact.

Lo believes there is a way to 'save the appearances,' to reconcile theory and fact in the world of financial economics.

For tomorrow's entry, I've summarized Lo's theory as I understand it. You can wait until then, or you can just follow the link, read his paper, and make up your own mind what he's saying and how far it is valid.