Adapting financial models to irrational investors

A review of Prof. Andrew W. Lo's book, Adaptive Markets: Financial Evolution at the Speed of Thought.

Paul Kaplan 23 October, 2018 | 5:00PM
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Economics in general, and financial economics in particular, has a long history of building elegant mathematical models. These models assume that economic agents, such as investors, are fully rational utility-maximizers and that markets are fully efficient. In finance, the best known of these models is the Capital Asset Pricing Model. Although the CAPM has repeatedly shown not to hold empirically, due to its simple and elegant conclusions it continues to be central to valuation and investment practice since no single model has emerged to replace it.

The main challenges to the assumption of rationality comes from the relatively new field of behavioural economics, which includes behavioural finance. So far, two of the leaders of this field have received the Nobel Memorial Prize in Economic Sciences; namely, Daniel Kahneman of Princeton in 2002 and Richard Thaler of the University of Chicago in 2017. Rather than making abstract assumptions about investor behaviour, Kahneman, Thaler and other behavioural economists used the experimental methods of psychology to determine by observation how real people go about making economic decisions. What they found was that real people behave very differently from the rational agents in traditional economics and finance. Instead of solving utility maximization problems, real people use various heuristics and are subject to various biases that lead them to make suboptimal decisions, and my even act against their own best interests. Such behaviour is often regarded as being irrational.

While traditional and behavioural economics have been at odds, there have been at least two efforts to reconcile them. One is the concept of popularity. I am a co-author of a forthcoming book on this. In the popularity approach, my co-authors and I extend the set of security characteristics that investors care about in the CAPM to include characteristics that are popular (or unpopular) for no rational reason. The result is a mathematical asset pricing model in which all characteristics that investors care about, both rational and irrational.

Professor Andrew Lo of MIT has taken a completely different approach. In papers published in 2004 and 2005, he departs from the mathematical approach of standard economics and finance and instead draws from evolutionary biology to explain investor and market behaviour. In doing so, he formulates the Adaptive Markets Hypothesis (AMH) which reconciles the Efficient Markets Hypothesis (EMH) with behavioural finance. In his 2017 book, Adaptive Markets: Financial Evolution at the Speed of Thought, he expands on and refines the AMH.

Here is a brief summary of some of the key takeaways from Professor Lo's book:

Economics and finance should be based on evolutionary biology
This is the central message of this book. Traditional economics is modeled off physics, with its elegant equations that describe how the universe works. But economies and markets are not subject to precise mathematical laws like the physical universe. They are made up of biological beings who are the product of millions of years of evolution. Hence, Professor Lo does not seek to explain human behaviour merely in terms of psychology, but in terms of the underlying evolved structure of the brain that leads to the behaviour that psychologists observe.

Many of the behaviours that behavioural economists describe as being irrational are maladaptive
Our species evolved in a very different environment than the one we live in today. We adapted to our earlier environments by developing various heuristics so that we would not have to spend time analyzing each situation we faced. But those are the wrong heuristics in a modern economy with capital markets. This does not make us irrational, just maladapted.

Reason and emotion are not in opposition, but rather go together
Professor Lo presents some fascinating evidence from the neuroscience literature on this. People who lose the emotional centres of their brains (say as the result of removing a brain tumour) also loose elements of their reasoning ability, such as the ability to prioritize tasks. This means that the dichotomy between rational behaviour and emotional behaviour is a false one.

Capital markets are analogous to ecosystems
Professor Lo draws on evolutionary biology to explain the behaviour of capital markets. He sees a market as an ecosystem, with groups of investors who behave in a common manner as species, such as pension funds. He says that the cycles that capital markets go through, with trends, panics, manias, bubbles and crashes, are analogous to what happens in natural ecosystems.

The AMH reconciles the EMH and behavioural finance
In the evolutionary framework, the EMH is a limiting case in which a market ecosystem is in a steady-state with constant environmental conditions. But environmental conditions are not constant, so markets will always be inefficient to some degree. Markets are most efficient when there are multiple species competing for scarce resources (profits) and are most inefficient when few species are competing for abundant resources.

Financial evolution occurs at the speed of thought
While biology evolution takes an extended period to occur, evolution in market ecosystems occurs rapidity. This is because unlike genes, which must be passed from generation to generation, ideas spread as soon as people are exposed to them, hence, at the "speed of though." Thus, financial markets evolve quite rapidly.

From these points, you can see that in this book, Professor Lo presents a very different approach to financial economics, far more like biology than physics. Time will tell whether his ideas take hold in either academia or in investment practice. In the meantime, I recommend his book for an informative and thought-provoking read that sheds a very different light on finance.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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