Wednesday, July 22, 2009

Lo and behold

Andrew Lo has done lots of good work on replicating hedge fund return distributions and other esoteric financial topics you don't give a shit about.  His more interesting contribution is what he calls the Adaptive Markets Hypothesis which he opposes to the standard that-can't-be-a-hundred-dollars-because-somebody-would-already-have-picked-it-up Efficient Markets Mythology.  His column in today's FT is worth a read, and has some priceless quotes:

Markets do function quite efficiently most of the time, aggregating vast amounts of disparate information into a single number – the price – on the basis of which millions of decisions are made. This feature of capitalism is an example of Surowiecki's "wisdom of crowds". But every so often, markets can break down, and the wisdom of crowds can become the "madness of mobs".


From an evolutionary perspective, markets are simply one more set of tools that Homo Sapiens has developed in his ongoing struggle for survival. Occasionally, even the most reliable tools can break or be misapplied.

leads to the punch line:

The implications of the AMH for regulatory reform are significant. Markets can be trusted to function properly in normal times, but if humans are subject to emotional extremes, animal spirits may overwhelm rationality, even among regulators and policymakers.

Therefore, fixed rules that ignore changing environments will almost always have unintended consequences: those enacted in the aftermath of crisis may be too severe during normal times, and those repealed after long periods of prosperity may lead to future excesses. The only way to break this vicious cycle is to recognise its origin – adaptive behaviour – and design equally adaptive regulations to counterbalance human nature.

This is good stuff, though I find it a little weird that he doesn't come to the most obvious conclusion, namely that one of the first adaptations that will happen in a market system is for some participant to try to game it.  Sure, markets are sometimes 'irrational' in a pure mob sense, perhaps due to leftover behavioral biases that make humans unsuited to dealing with money in prefect homo economicus fashion.  However, it seems clear that the bigger problem is the inevitable tendency to hack the system, which is anything but irrational from the perspective of the hacker, even if it sets off a chain of events that looks like irrational behavior on the part of the system.  Naturally, every participant can engage in this type of hacking, which would lead you back to the efficient markets hypothesis if it weren't for the winner-take-all nature of hacking the political system.

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