Adaptive Markets

Adaptive Markets : Financial Evolution at the Speed of Thought

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A new, evolutionary explanation of markets and investor behavior Half of all Americans have money in the stock market, yet economists can't agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe--and as financial bubbles, crashes, and crises suggest. This is one of the biggest debates in economics and the value or futility of investment management and financial regulation hang on the outcome. In this groundbreaking book, Andrew Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist. Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, Adaptive Markets shows that the theory of market efficiency isn't wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit. Lo's new paradigm explains how financial evolution shapes behavior and markets at the speed of thought--a fact revealed by swings between stability and crisis, profit and loss, and innovation and regulation.
A fascinating intellectual journey filled with compelling stories, Adaptive Markets starts with the origins of market efficiency and its failures, turns to the foundations of investor behavior, and concludes with practical implications--including how hedge funds have become the Galapagos Islands of finance, what really happened in the 2008 meltdown, and how we might avoid future crises. An ambitious new answer to fundamental questions in economics, Adaptive Markets is essential reading for anyone who wants to know how markets really work.
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Product details

  • Hardback | 512 pages
  • 152 x 235 x 40.64mm | 822g
  • New Jersey, United States
  • English
  • 13 color illus. 28 line illus. 9 tables.
  • 0691135142
  • 9780691135144
  • 26,798

Back cover copy

"Andrew Lo combines wonderfully broad scholarship and a delightfully instructive style to present dramatically new perspectives on how markets work and how they can be regulated more effectively. This important book will teach and entertain, and should influence those charged with keeping markets healthy."--Simon A. Levin, Princeton University

"Adaptive Markets will appeal to anyone who distrusts dogmatic economic theories and thirsts for a coherent view of how market economies produce both great gain and great pain for societies. Andrew Lo integrates a deep understanding of finance with a broad knowledge of biology, psychology, and ethics to offer a tantalizing vision of how financial engineering could become a powerful force for a more just, healthy, and prosperous world."--Peter Hancock, President and CEO, AIG

"We tell stories, we learn from them, and we make them up. In this magnificent book, Andrew Lo explains how our attraction to stories drives markets, explains past catastrophes, and suggests future opportunities for world-saving financial engineering. And he packages it all in fascinating stories of his own."--Patrick Henry Winston, Massachusetts Institute of Technology

"Andrew Lo is a brilliant financial economist, visionary innovator, bold contrarian, gifted writer, and an unrelenting idealist. These traits are evident in this wonderful book, which traces the 'evolutionary explosion of financial innovation' that began with Vanguard's creation of the first index mutual fund in 1974, tracking the S&P 500 Index. I continue to hold to index funds, but Dr. Lo's book persuades me to keep a mind that is open--or at least ajar--to the new world of investment technology, investor preferences, and transaction efficiency, and to the wisdom of those who are smarter than I am."--John C. Bogle, founder of the Vanguard Group and the First Index Mutual Fund, and author of The Little Book of Common Sense Investing

"This is a wonderful book. Andrew Lo traces a journey in which he reconsiders rationality in economics, moving from the efficient market hypothesis to his own Adaptive Markets Hypothesis through psychology, neuroscience, biology, and studies of financial innovations and crises. The book presents many valuable findings and is also full of emotion--enthusiasm, joy, frustration, and pain. It is itself a manifestation of the important finding that rational thinking and emotion go together."Nobuhiro Kiyotaki, Princeton University
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Table of contents

Introduction 1 Financial Fear Factor 1 Don't Try This At Home 4 The Great Divide 6 "It's the environment, stupid!" 8 Revenge of the Nerds 10 1 Are We All Homo economicus Now? 12 Tragedy and the Wisdom of Crowds 12 A Random Walk through History 16 The Birth of Efficient Markets 20 Efficient Markets Unpacked 25 What to Expect When You're Expecting 28 Efficient Markets in Action 38 2 If You're So Smart, Why Aren't You Rich? 45 Rejecting the Random Walk 45 Risk versus Uncertainty and the Ellsberg Paradox 51 Losing Hurts More than Winning Feels Good 56 No-Limit Texas Hold 'em, Rogue Traders, and Regulators 59 Probability Matching and March Madness 62 Humans as Prediction Machines 65 It Takes a Theory to Beat a Theory 69 Culture Shock 71 3 If You're So Rich, Why Aren't You Smart? 75 Looking under the Hood 75 The Microscope of Neuroscience 76 Fear 78 Pain 85 Pleasure and Greed 87 Wired-Up Traders 92 The Stuff Good Traders Are Made Of 94 Mind over Money via Neural Currency 96 I Want It All, and I Want It Now 98 4 The Power of Narrative 102 A New Meaning of Rationality 102 The Human Fire Alarm and Sprinkler System 104 The Fear Factor and Finance 106 I Know You Know That I Know 108 Homo economicus and the Left Hemisphere 113 The Prefrontal Cortex as CEO 117 The Power of Self-Fulfilling Prophecies 123 Barbara Ficalora, the Best Third Grade Teacher Ever 124 Narrative Is Intelligence 128 5 The Evolution Revolution 135 A Day at the Zoo 135 The Evolution Revolution 136 Just-So Stories or Scientific Fact? 138 The Power of Selection 141 Variety Is the Spice of Life 144 "It's the environment, stupid!" 146 The Emergence of Homo sapiens 150 Enter Homo economicus 152 An Evolutionary Pecking Order 156 Swedish Twins and Savings 158 Evolution at the Speed of Thought 162 Sociobiology and Evolutionary Psychology 168 Survival of the Richest? 175 6 The Adaptive Markets Hypothesis 176 It Takes a Theory to Beat a Theory 176 Simon Says Satisfice 177 The Superman Jacket 182 The Adaptive Markets Hypothesis 185 Probability Matching Explained 189 Nature Abhors an Undiversified Bet 195 "It's the environment, stupid!" All Over Again 196 Homo economicus and Idiosyncratic Risk 198 The Origin of Risk Aversion 203 Efficient versus Adaptive Markets 206 Waylaid by Physics Envy 208 On the Shoulders of Giants 214 7 The Galapagos Islands of Finance 222 Quantum Mechanics 222 Mission Impossible 224 The Islands of Evolution 225 Hedge Fund Archipelago 227 An Evolutionary History of the Hedge Fund 231 The Birth of Quants 235 The Revenge of the Nerds 236 Quant Goes Mainstream 240 The Evolution of the Random Walk 244 Cell Phones and Kerala Fishermen 246 8 Adaptive Markets in Action 249 The Traditional Investment Paradigm 249 The Great Modulation 254 A New World Order 256 Risk/Reward and Punishment 258 The Democratization of Investing 263 New Species of Index Funds 265 Smart Beta versus Dumb Sigma 267 Disbanding the Alpha Beta Sigma Fraternity 271 The Random Walk Revisited 277 A New Investment Paradigm 282 The Quant Meltdown of August 2007 283 Forensic Finance 284 Adaptive Markets and Liquidity Spirals 289 1998 versus 2007 292 9 Fear, Greed, and Financial Crisis 296 Ecosystem Ecology 296 Financial Crisis 101 298 Clear as Rashomon 301 Not Enough Skin in the Game? 303 Regulators Asleep at the Wheel? 306 Red Pill or Blue Pill? 312 Could We Have Avoided the Crisis? 314 The Adaptive Markets Hypothesis Explains 318 (Ab)Normal Accidents 320 Liquidity Withdrawal Symptoms 324 10 Finance Behaving Badly 330 Finance Rules 330 Out-Ponzi-ing Ponzi 332 The Ultimatum Game 335 A Neuroscience of Morality? 338 Is Finance Fair? 340 Finance and the Gordon Gekko Effect 345 Regulatory Culture 349 Environment Strikes Again 352 Moore's Law versus Murphy's Law 355 The Tyranny of Complexity 361 11 Fixing Finance 365 An Ounce of Prevention 365 Ecosystem Management 366 Adaptive Regulation 368 Law Is Code 371 Mapping Financial Networks 375 The CSI of Crises 378 Privacy with Transparency 384 Anti-Gekko Therapies 387 12 To Boldly Go Where No Financier Has Gone Before 395 Star Trek Finance 395 "Computer, manage my portfolio!" 397 Curing Cancer 400 Eliminating Poverty 411 A New Narrative 415 I Want To Be Harvey Lodish 418 Notes 421 References 439 Acknowledgments 463 Index 469
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Review quote

"Mr. Lo makes a convincing argument and he also uses the book to lay out some interesting ideas--such as a huge, diversified fund that would invest in a range of potential cancer treatments."--Economist "[A] remarkable new book... Lo's book will be read and read widely... His insights should allow investors and regulators alike to manage risks better. They should read it."--John Authers, Financial Times "This new book will become another essential read for anybody interested in financial markets... [It] is a thoroughly interesting and enjoyable read. It is not technical, the explanations are super-clear, and there is some excellent story telling."--Enlightened Economist "[Lo] has a knack for providing a telling anecdote or story to illustrate his point. More important, he also avoids being condescending or triumphalist."--Matthew Partridge, Money Week "Using research in evolutionary biology, psychology, neuroscience and artificial intelligence, Mr. Lo ... explains how human behavior shapes the markets, leading to swings between stability and instability, profit and loss, innovation and regulation."--Pensions & Investments
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About Andrew Lo

Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. He is the author of Hedge Funds and the coauthor of A Non-Random Walk Down Wall Street and The Econometrics of Financial Markets (all Princeton). He is also the founder of AlphaSimplex Group, a quantitative investment management company based in Cambridge, Massachusetts.
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Rating details

313 ratings
4.17 out of 5 stars
5 41% (129)
4 40% (125)
3 15% (47)
2 3% (8)
1 1% (4)
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