Adaptive Markets: Financial Evolution at the Speed of Thought, by Andrew W. Lo (Princeton, 504 pp., $37.50)

Andrew Lo’s ambitious book offers a welcome, fresh look at how financial markets work and why they sometimes fail. Lo first sets out to reveal the inadequacies of the dominant, purely rationalistic efficient-markets hypothesis (EMH) of finance. Then, with his own adaptive-markets hypothesis (AMH), he offers a cogent expansion of this thinking to accommodate emotion and irrationalities—an insight gaining traction in the economics field. He is generally successful, though he sometimes oversimplifies what he wishes to criticize, overstates the originality of his own insights, and, on at least one occasion, ignores the implications of one of those insights. Still, a book this complex and wide-ranging could hardly avoid a few lapses.

Several times, Lo’s emphasis on both emotion and rationality brought me back to the shock of September 11, 2001. The offices where I worked then, though at some distance from the World Trade Center, offered a full view of events that sinister morning. I remember that when I saw the first tower fall, I denied the evidence before my eyes, a natural human response that Lo explains well. When, in the next instant, I accepted the horror of reality, I had an impulse to run—not out of the room but out of New York, to start a new life in the relative safety of so-called flyover country. That response is natural, too, Lo shows. Yet, even as I contemplated life outside of the big city, my many years in finance prompted a different reaction. “Now,” it occurred to me, “is the time to get a good price on a Manhattan apartment.” That cold reaction to disaster reflected the pure rationality of the efficient-markets approach; otherwise, it informed nothing of my experience that day.

Because Adaptive Markets is a reaction to the narrowness of prevailing financial thought, it begins, appropriately, with a detailed history of how the efficient-markets hypothesis developed. Lo’s careful treatment even includes brief biographies of some of the theory’s leading proponents, many of them Nobel Laureates. As Lo describes it, these thinkers see markets as guided by a purely rational creature, homo economicus, who feels neither fear nor triumph but continually weighs opportunities against risks in order to optimize his strategies, purchases, sales, and holdings. The implication of this line of reasoning, taken to its logical extreme, is that markets become such efficient processers of information that no individual can find an opportunity not already exploited—hence the joke about the impossibility of finding $20 on the street, because someone must have picked it up already. With no hope of getting ahead of this calculating machine, investors, according to a strict reading of the EMH, might as well give up the effort and passively invest in a broad range of assets. 

Having characterized dominant financial thought in this way, Lo then sets out to show how limited it is and the necessity of broadening it. That effort directs three of his twelve chapters—more than 100 pages—to a review of opposing evidence, from neuroscience and evolutionary theory. Here, he demonstrates beyond cavil that people often make less than fully rational choices and offers convincing reasons why this is so. Of course, human irrationality won’t come as news to anyone who has ever dated or attended a family reunion, but the scientific evidence creates a compelling need to account for emotion in financial theory.

Though his effort his impressive and enlightening, Lo fails to discredit the efficient-market hypothesis as thoroughly as he implies. He does show conclusively that no individual is entirely rational, but the rationalistic theory never claims that individuals are entirely rational. Rather, it argues that at any moment, enough market participants can dispassionately assess information to move markets toward rational conclusions. Except when there is a shock to the system, emotional influences effectively cancel one another out. Reason ultimately prevails. Though Lo acknowledges this aspect of EMH elsewhere in his book, he fails to do so here.

Sometimes, he even seems to stack the deck. One experiment, for instance, examines currency traders for levels of emotion on the job. The tests seem valid enough, but Lo surely knows that traders don’t move markets: they execute decisions made by others, sometimes arrived at over the course of several days or weeks. Warren Buffett, George Soros, and others reach their conclusions not by sitting in trading turrets but through due deliberation in offices and investment meetings. It is there that he should look to find market-moving emotion.

Such failings weaken Lo’s case, but he is on firmer footing when discussing broader market irrationalities, such as during the 2008–09 financial crisis. Here, he draws on the psychological work of Herbert Alexander Simon, who demonstrated decades ago the psychological impossibility of optimization. Reality, Simon observed, presents too many possibilities, even in “very limited situations.” People tend to rely, Simon argued, on rules of thumb that simply work well enough, not the thorough analysis and optimal choice suggested by the EMH. They develop these heuristics, as Lo calls them, over time to suit particular environments. As long as these environments remain relatively stable, outcomes seem rational. But when the environment changes, these heuristics break down, chaos reigns, rationality evaporates, and fight-or-flight instincts prevail. Rationality and order only seem to return when people can develop heuristics better suited to the new environment.

This insight offers a number of ways to broaden financial thinking. To be sure, some financial practitioners (investors, economists, traders) might belittle it, claiming, with some justice, that they have long anticipated Lo’s criticisms of the EMH, and that he has done little more than describe how they bend the rationalist hypotheses daily to suit reality. Practitioners have long known that even in stable environments, it takes time for markets to approach a semblance of the efficiencies that the EMH describes; they use that time to capitalize on opportunities whose existence the theory’s strictest application denies. They have also long observed, as Lo also points out, that it takes longer than the theory suggests for riskier assets to pay the superior returns it logically promises. Accepting the link between risk and return, practitioners nonetheless tell investors that the superior returns of risky assets are only for people who can do without the money for years. They usually speak in terms of ten-year intervals; they would scoff at Lo’s almost gleeful finding that the relationship breaks down over five-year intervals.

One particular oversight, however, disappoints me. When reviewing evolutionary theory, Lo shows how in periods of change, a species’ survival depends on a diversity of answers, including not only the genetic mutations usually associated with evolution but also the formulation of new heuristics for a human community. If some members go one way and others another, the odds are improved that some part of the group or species will survive. A single answer for the whole community, if wrong, spells extinction. With this insight, evolutionary theory would seem to harmonize the contrasting perspectives of Adam Smith, Friedrich Hayek, and others, who argued for the superiority of market diversity in meeting human needs and the danger of singular, community-wide answers implicit in government direction. Developing this point would have made a welcome addition to Lo’s analysis, but he seems not to have noticed its importance. Later in the book, he demonstrates that he missed it entirely, when he suggests that the U.S. could guard against future financial crises with a kind of overarching regulatory body, staffed by those proverbial “disinterested” experts. Turning away from his own support for market-based answers and embracing top-down direction, Lo succumbs to what Hayek described as the intellectuals’ “fatal conceit.”

Frustrating as this failure and some of Lo’s other quirks are, Adaptive Markets makes a valuable and welcome contribution, rewarding the reader by broadening and improving our understanding of finance and markets—in stable and unstable times.

Photo by Peter Macdiarmid/Getty Images


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