NEW YORK (Reuters Breakingviews) - Invited to review a book or two on the financial crisis for an economics journal in 2011, Andrew Lo found the ones he read unsatisfying. Their gaps and inconsistencies failed to tell the full story, prompting him to extend his search. When an editor finally called time a year later, Lo submitted a review of 21 books.
Now Lo, who is director of MIT’s Laboratory for Financial Engineering and chairman and chief strategist of investment adviser AlphaSimplex, has added his own tome to the pile. In “Adaptive Markets: Financial Evolution at the Speed of Thought,” he argues that it’s time to bury the efficient-market hypothesis championed by University of Chicago economist Eugene Fama. That theory posits that stock prices reflect all available information, making it impossible for an investor to consistently beat the market.
Fama’s idea has faced plenty of challenges over the years, not least from the 1987 stock-market crash that saw the Dow Jones Industrial Average fall a record 22 percent in one day. Lo has delivered some of the blows. One of his early research efforts was as co-author of a 1985 paper that proved stock prices don’t fluctuate randomly. Yet the underlying assumption of efficient-market theorists – that investors are rational profit maximizers – has proved remarkably resilient. Lo is determined to shake that foundation.
He starts by diving into neuroscience and evolutionary biology. Magnetic resonance imaging of test subjects in game simulations has shown that the prospect of winning money releases dopamine in the brain – the trader’s equivalent of a cocaine fix. Rather than weigh all possible options, humans make decisions using short cuts. If they didn’t, it would be hard to get dressed in the morning.
In short, economic actors are human: fighting to survive, making mistakes because of their biases, yet still capable of learning and adapting. That is why markets can seem bipolar, riding the momentum of low volatility and rising prices until some factor - trivial or substantive - triggers a freakout.
The story is well told, but it’s hardly new to people familiar with the work of behavioral economists like Richard Thaler and Daniel Kahneman. Indeed, any casual observer of the economy is presented with daily evidence of human frailty. The financial crisis showed how such panic can scale in today’s global markets. The question is what to do with this insight.
Lo would like to see more examples like countercyclical capital buffers, which regulators have imposed on banks in an attempt to rein in excesses. He also suggests a financial version of the U.S. National Transportation Safety Board, which would investigate market crashes and provide authoritative remedies.
As an investment adviser, Lo’s real interest is in the behavior of investors. He offers some interesting ideas about constructing dynamic index funds that would reduce stock market exposure when volatility spikes. Another suggestion is to create venture-capital mega-funds to place bets on, say, cancer-curing drug treatments or climate-change technologies, in the hope that a few will pay off. It sounds utopian, but Lo is determined to change that perception.
Academic proponents of efficiency receive equally short shrift from Richard Bookstaber. Although he holds a Ph.D. in economics from MIT, the title page of “The End of Theory: Financial Crises, the Failure of Economics and the Sweep of Human Interaction,” leaves little doubt about which side of the debate he favors.
Bookstaber covers much the same ground as Lo, but from the perspective of a financial engineer. That’s not surprising for a man who worked as a proprietary trader at Morgan Stanley and oversaw risk management at hedge fund Moore Capital. The complexity of the financial system and the ability of traders to find ways around static rules demands agility from managers and regulators.
Bookstaber’s proposed solution is agent-based modeling, which eschews fixed rules for computer models that mimic how institutions behave and react to changing market conditions. Think narrative, not mathematics, says the self-proclaimed frustrated novelist. The aim is to provide a kind of weather forecast for financial markets.
The idea has been around for some time. Lo did some pioneering work in the late 1990s. At the U.S. Treasury’s Office of Financial Research, where he works, Bookstaber wrote a 2014 paper on the use of agent-based models to try to avert funding crises like the one that brought down Lehman Brothers.
The devilish thing about behavior, though, is that humans can adapt to almost anything. Models can be helpful and regulators should think about how real bankers, traders and investors behave. But any successful attempt at reducing risk has the potential to breed complacency. Hyman Minsky wrote that financial stability carries the seeds of its own demise because it encourages risk taking. It’s a simple yet profound behavioral insight that neither Lo nor Bookstaber bothers to mention.
It’s a curious oversight, but one that can be forgiven. After all, the authors are only human.
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