Can the Market be both Rational and Irrational?

MIT Sloan Professor Andrew Lo proposes a new, evolutionary explanation of why financial markets behave the way they do 

A groundbreaking new book by award-winning financial expert and MIT professor Andrew W. Lo addresses the basic question facing both economists and anyone with investments in the stock market: Are financial markets rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe?

In Adaptive Markets: Financial Evolution at the Speed of Thought (Princeton University Press) Lo cuts through disagreements to propose a new framework of analysis called the Adaptive Markets Hypothesis. Drawing on recent research in evolutionary biology, psychology, neuroscience, and artificial intelligence, Lo explains how human behavior shapes the markets, leading to swings between stability and instability, profit and loss, and innovation and regulation.

Adaptive Markets culminates more than 20 years of research by Lo, the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. Lo is author of Hedge Funds: An Analytic Perspective and the coauthor ofA Non-Random Walk Down Wall Street and The Econometrics of Financial Markets.

Using clear, compelling, accessible language, Lo shows how long-established economic theories are not wrong, but fall short of explaining reality.  “The Adaptive Markets Hypothesis reconciles the two competing schools of thought in financial economics, both of which are compelling in their own right even though they’re incomplete,” he said.

One important implication for portfolio managers is that passive investing is changing and investors have to adapt. “Traditional investment advice is a bit like trying to prevent teenage pregnancies by asking teenagers to abstain—it’s not bad advice, but it’s unrealistic,” Lo said.

Lo takes a hard look at the roots of the 2007–2008 financial crisis and whether the next crisis is looming. “Today’s markets are now much more responsive to intervention by governments and their central banks and punctuated by the irregular cycle of fear and greed,” Lo said. “So since 2007 and 2008, we’ve seen a very different market dynamic than over the previous six decades. The point of Adaptive Markets is simply not to be wedded to any static theory, but rather to understand how the nature of markets can change.”

Using simple analogies and real-life examples, Adaptive Markets is a travelogue of Lo’s intellectual journey from die-hard efficient market disciple to proponent of applying theories of human behavior to financial markets. He does this without a single mathematical formula in the book, which, he admits, is no easy feat for someone from MIT.

In the chapter,  “If You’re So Smart, Why Aren’t You Rich?” Lo explores whether it’s possible to beat the stock market using quantitative models. In “If You’re So Rich, Why Aren’t You Smart?” he examines the neuroscientific basis of irrational behavior.  In “To Boldly Go Where No Financier Has Gone Before,” he looks at how financial tools, properly applied, could address social ills, including cancer.

“Before we can fix finance, we need to understand where financial crises come from, and the Adaptive Markets Hypothesis has a clear answer: crises are the product of human behavior coupled with free enterprise,” Lo said.  “If you can eliminate one or both of these two components, you can eliminate financial crises. Otherwise, crises are an unavoidable fact of modern life. Human misbehavior is a force of nature, not unlike hurricanes, flash floods, or earthquakes, and it’s not possible to legislate away these natural disasters.”

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.