Adaptive Markets Adaptive Markets Financial Evolution at the Speed of Thought Andrew W Lo PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD Copyright © 2017 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, Oxford Street, Woodstock, Oxfordshire OX20 1TR press.princeton.edu Jacket design by Alex Robbins All Rights Reserved Library of Congress Control Number 2016961979 ISBN 978- 0- 691-13514- British Library Cataloging-in-Publication Data is available Th is book has been composed in Minion Pro text with Din Pro display Printed on acid-free paper ∞ Printed in the United States of America 10 To Nancy, Derek, and Wesley Contents Introduction Financial Fear Factor Don’t Try This At Home The Great Divide “It’s the environment, stupid!” Revenge of the Nerds Chapter Are We All Homo economicus Now? Tragedy and the Wisdom of Crowds A Random Walk through History The Birth of Efficient Markets Efficient Markets Unpacked What to Expect When You’re Expecting Efficient Markets in Action Chapter If You’re So Smart, Why Aren’t You Rich? Rejecting the Random Walk Risk versus Uncertainty and the Ellsberg Paradox Losing Hurts More than Winning Feels Good No-Limit Texas Hold ’em, Rogue Traders, and Regulators Probability Matching and March Madness Humans as Prediction Machines It Takes a Theory to Beat a Theory Culture Shock Chapter If You’re So Rich, Why Aren’t You Smart? Looking under the Hood The Microscope of Neuroscience Fear Pain Pleasure and Greed Wired-Up Traders The Stuff Good Traders Are Made Of Mind over Money via Neural Currency I Want It All, and I Want It Now 1 10 12 12 16 20 25 28 38 45 45 51 56 59 62 65 69 71 75 75 76 78 85 87 92 94 96 98 viii • Contents Chapter The Power of Narrative A New Meaning of Rationality The Human Fire Alarm and Sprinkler System The Fear Factor and Finance I Know You Know That I Know Homo economicus and the Left Hemisphere The Prefrontal Cortex as CEO The Power of Self-Fulfilling Prophecies Barbara Ficalora, the Best Third Grade Teacher Ever Narrative Is Intelligence Chapter The Evolution Revolution A Day at the Zoo The Evolution Revolution Just-So Stories or Scientific Fact? The Power of Selection Variety Is the Spice of Life “It’s the environment, stupid!” The Emergence of Homo sapiens Enter Homo economicus An Evolutionary Pecking Order Swedish Twins and Savings Evolution at the Speed of Thought Sociobiology and Evolutionary Psychology Survival of the Richest? Chapter The Adaptive Markets Hypothesis It Takes a Theory to Beat a Theory Simon Says Satisfice The Superman Jacket The Adaptive Markets Hypothesis Probability Matching Explained Nature Abhors an Undiversified Bet “It’s the environment, stupid!” All Over Again Homo economicus and Idiosyncratic Risk The Origin of Risk Aversion Efficient versus Adaptive Markets Waylaid by Physics Envy On the Shoulders of Giants 102 102 104 106 108 113 117 123 124 128 135 135 136 138 141 144 146 150 152 156 158 162 168 175 176 176 177 182 185 189 195 196 198 203 206 208 214 Contents • ix Chapter The Galapagos Islands of Finance Quantum Mechanics Mission Impossible The Islands of Evolution Hedge Fund Archipelago An Evolutionary History of the Hedge Fund The Birth of Quants The Revenge of the Nerds Quant Goes Mainstream The Evolution of the Random Walk Cell Phones and Kerala Fishermen Chapter Adaptive Markets in Action The Traditional Investment Paradigm The Great Modulation A New World Order Risk/Reward and Punishment The Democratization of Investing New Species of Index Funds Smart Beta versus Dumb Sigma Disbanding the Alpha Beta Sigma Fraternity The Random Walk Revisited A New Investment Paradigm The Quant Meltdown of August 2007 Forensic Finance Adaptive Markets and Liquidity Spirals 1998 versus 2007 Chapter Fear, Greed, and Financial Crisis Ecosystem Ecology Financial Crisis 101 Clear as Rashomon Not Enough Skin in the Game? Regulators Asleep at the Wheel? Red Pill or Blue Pill? Could We Have Avoided the Crisis? The Adaptive Markets Hypothesis Explains (Ab)Normal Accidents Liquidity Withdrawal Symptoms 222 222 224 225 227 231 235 236 240 244 246 249 249 254 256 258 263 265 267 271 277 282 283 284 289 292 296 296 298 301 303 306 312 314 318 320 324 ... Savings Evolution at the Speed of Thought Sociobiology and Evolutionary Psychology Survival of the Richest? Chapter The Adaptive Markets Hypothesis It Takes a Theory to Beat a Theory Simon Says Satisfice... the power of financial markets, but 2008 was the year the global financial crisis gave the entire world a taste of the finance of fear That was the year Lehman Brothers went belly up, stock markets. .. new narrative to make sense of the wisdom of crowds, the madness of mobs, and evolution at the speed of thought Our search for this new narrative begins with a terrible catastrophe If markets