Lo, Adaptive Markets

Andrew W. Lo first proposed the adaptive markets hypothesis (AMH) in 2004 as an alternative to the efficient markets hypothesis (EMH). Four years later, in Hedge Funds: An Analytic Perspective, he reiterated his hypothesis. Few people did cartwheels over it. This past year, he wrote a more popular, though nearly 500-page, book to advance his view, Adaptive Markets: Financial Evolution at the Speed of Thought (Princeton University Press).

The first third of the book - dare I say the best third of the book? - is a stroll through, and critique of, competing hypotheses and an introduction to evolution, with the mantra "It's the environment, stupid!" emerging as a dominant motif and the notion of evolution at the speed of thought becoming an organizing principle. ("We can use our brains to test our ideas in mental models, and to reshape them if they're found lacking. This is still a form of evolution, but it's evolution at the speed of thought.")

As Lo repeats more than once, it takes a theory to beat a theory. His hypothesis is, he suggests, "the new contender. But these are still early days for the challenger - the incumbent has had a five-decade head start - and a great deal more research is needed before these ideas become as immediately useful as the existing models of quantitative finance." This is indeed the problem for the AMH. It's just not immediately obvious how to use it in a way that is neither trivial (e.g., market regimes change) nor supportive of far too many alternatives.

According to the AMH, "market behavior adapts to a given financial environment." The EMH, in Lo's view, describes an abstraction, an idealized market. "An efficient market is simply the steady-state limit of a market in an unchanging financial environment."

Lo offers a new investment paradigm to replace or modify the five principles of the traditional investment paradigm.

1. The risk/reward trade-off. Although during normal market conditions there's a positive association between risk and reward, "when the population of investors is dominated by individuals facing extreme financial threats, they can act in concert and irrationally, in which case risk will be punished."

2. Alpha, beta, and the CAPM. "Knowing the environment and population dynamics of market participants may be more important than any single factor model."

3. Portfolio optimization and passive investing. "Portfolio optimization tools are only useful if the assumptions of stationarity and rationality are good approximations to reality." As for passive investing, "risk management should be a higher priority."

4. Asset allocation. "The boundaries between asset classes are becoming blurred."

5. Stocks for the long run. "Over more realistic investment horizons,... investors need to be more proactive about managing their risk."

Lo is a good enough scientist to realize that "between theory, data, and experiment, the Adaptive Markets Hypothesis will survive, perhaps be replaced with an even more compelling theory in the future, or fall short and be forgotten." I hope it's not the last alternative, because even though I have my doubts about its efficacy, the hypothesis has some very attractive features.