This book is geared for the intermediate-level investor, and might be useful to anyone not conversant in (but curious about) the various intellectual fads in academic finance over the past four or five decades. Likewise it will be revelatory for anyone who hasn't really thought to apply ideas from biology or evolution to investing.
An advanced investor, however, will find this book breaks little new ground and thus is not a good use of time.
Let's be a bit blunt. Adaptive Markets was harder to get through than it should have been. It should have been a much more readable and competent review of academic financial thought--and it should have been shortened by at least a third. Readers will likely find it irritating to have to wait until page 185 to actually learn the author's theory, after first having to sit through long lectures on orthodox academic finance (including EMH, CAPM, and other equally useless ideas), then a review of evolution, biology and evolutionary psychology, and only then getting to the author's core theory.
Some of the book's key ideas are much less original than the author thinks. The notion that markets are not "efficient" but rather biological, adaptive and evolutionary has been around for decades, and economists across the spectrum from Hayek to Krugman have long commented on this. The idea that humans are adapted for survival rather than adapted for "economic rationality" (in the pointy-headed academic sense) is another idea that is neither original nor interesting--although it bears repeating for those who may still foolishly disbelieve it.
On the other hand, some of the book's notions, many of them mined from evolutionary biology, are genuinely useful reminders: see for example the benefits of not being too well-fitted for your environment--because your environment might change faster than you can. It pays to think about this as an investor: it focuses you on your investing "environment" (Is it a bull market or a bear market? Should I be selling vol or buying it? Does the environment favor mo-mo or value or what? and so on) and thus keeps you adding tools and skills so you can remain an adaptable, all-weather investor.
A few more (blunt) thoughts. Unfortunately, author Andrew Lo reveals significant gaps in knowledge in this book. He should know his Dawkins better, and at the least he should have read The Selfish Gene, which is directly relevant to many of his ideas. He seems unaware of the giant controversies surrounding the now-debunked Milgram experiments. He doesn't appear to know his Hyman Minsky at all--although admittedly neither did I until a couple of books ago. If he did, though, he'd see that much of his thinking about instability and adaptation has already been written, albeit incomprehensibly (Minksy was well-known to be a terrible writer).
Worst of all, the author doesn't address (and doesn't appear to know) the difference between ensemble probability problems and one-off probability problems when it comes to behavioral finance. Think of it this way: when a behavioral finance "expert" asks you an economic question about "expected value" or if he offers you some bet involving gain or loss based on a coin toss, it really, really matters how many times you get to play out the game. Your answer, and your aversion to loss, will be a lot different for a one-turn bet (one-off probability) versus if you get repeated tries at the bet (ensemble probability). This is the idea of ergodicity, and the author seems totally unaware that ergodicity is a catastrophic problem for behavioral finance. Most of those sneaky economic payoff questions that Daniel Kahneman and Amos Tversky dreamed up in their behavioral finance lab totally ignore (some might say mendaciously ignore) how many times you get to play! An established academic like Dr. Lo really should have already read Ole Peters, or, at the very very least, should be conversant in Nassim Taleb's works questioning the usefulness and the rigor of much of behavioral finance.
Look, I'm just a nobody blogger, I'm far from an expert on ergodicity economics, and it's only tangential to my field--yet I still know a modest amount about it. The idea that a tenured finance professor at MIT left such major stuff out of his book is vaguely horrifying. He should know better.
All criticisms aside, this professor appears to be a really good dude to work with if you're a PhD candidate: he doesn't take first author credit on all the zillions of papers his grad students publish, and he talks about his PhD students quite favorably throughout the book.
One final thought. Academic finance is an odd domain: whenever an academic writes a book about investing, it reminds me of Nassim Taleb's sarcastic comment about "lecturing birds on how to fly." Birds already know perfectly well how to fly, they don't need your theories.
[For the love of God read no further, the rest of this post is just notes and thoughts.]
Notes:
Introduction:
1) Our fears were designed for millions of years ago, financial markets and money have only been around for hundreds/thousands of years.
2) Adaptive markets versus efficient markets, "financial markets behave more like biology than physics"; like an ecosystem of living organisms competing to survive. This is not an original idea by any stretch.
3) The author describes a great divide between rational man/efficient markets economics and behavioral economics. The irony here is both of these poles of thought have been thoroughly debunked! Does it really matter that there's a divide between two bodies of though that have both been found to be mostly wrong?!
4) Market still look efficient under certain conditions of stability (Minsky has already pointed this out).
5) "...financial markets don't follow economic laws. Financial markets are a product of human evolution, and follow biological laws instead." "Irrational" financial behavior is behavior that's not yet adapted to the modern environment.
Chapter 1: Are We All Homo Economicus Now?
6) The Challenger disaster and the fact that the stock market figured it out within minutes even though the Rogers Commission didn't figure out the O-ring, manufactured by Morton Thiokol, was problem until five months later. Thus how could the stock market "know" this within one session?
7) Martingale: a truly fair game like a casino game with known odds and that favor the players equally; the implication here is that "your winnings or losses can't be forecast by looking at your past performance" ... Basically a discrete probability circumstance.
8) Alphonse Bachelier's Théorie de la Spéculation: random walk theory, "mathematical expectation of the speculator was zero." Economist Paul Samuelson was sent Bachelier's thesis and used it to arrive at EMH, but "he withheld publishing it for years" because he thought it was either trivially obvious or sweepingly important, it was also independently developed also by Eugene Fama.
9) [It's hilarious to me that Eugene Fama failed to find a way to beat the market... and therefore concluded that it was "efficient" and unbeatable. Who would have thought such a titan of academic finance could commit such a painful error of solipsism?]
10) G.C. Haas and Mordecai Ezekiel in the 1920s ran forecasts for hog prices and discovered the supply/demand curve, also discovering that there was not a stable equilibrium for prices. Later this was handled with the "cobweb theory" of prices, an equilibria moving in cobweb-like circles across discrete lumps of time, like turns of a game. [This has to do with supply decisions made by hog producers that tend to lag the demand signals in the marketplace, there's a lag due to the time to market problem.]
11) Herbert Simon and bounded rationality; Milton Friedman and adaptive expectations; John Muth and rational expectations: systems adjust in cycles to outside shocks, Muth and his "antitheory" remain obscure.
12) 1976: Robert Lucas takes Muth's idea and uses it to explain why the Philips Curve (the relationship between unemployment and inflation) broke down in the 1970s stagflation era: people have "rational expectations" about government macro policy and then respond to that policy; this is what messes up the assumed result of that government policy, the "Lucas critique" of Keynesian macroeconomic policymaking.
13) [Note also once you understand money printing and the expansion of the money supply you realize that the Phillips curve is the stupidest thing ever, it's a bouncing ball or a "look at that dog with the poofy tail!" that they point at to make you ignore the real cause of inflation]
14) [Intriguing also how many academics who genuinely discovered tremendously important things (like Jack Muth or Louis Bachelier) are simply ignored, forgotten; these guys then teach in total obscurity, and worse: other people either co-opt or outright steal their ideas and become famous and wealthy doing so! It makes you realize that most of the good stuff we never see or hear about, and many of the people we think invented things actually didn't. Thus Stigler's Law of Eponymy: the idea that no scientific discovery is named after its original discoverer, which I read somewhere actually is also named after the wrong person.]
15) Prediction markets as examples of efficient markets that are useful, betting on odds of an event happening. [Is this really true? These markets typically can be moved pretty easily with limited capital...]
16) Thinking of EMH as more "wisdom of crowds" than financial catechism, it actually works in prediction markets and in cheap ways to compare products, etc (see the author testing various consumer products using students and a trading platform, which within a few minutes would sort products by value and quality very quickly).
17) EMH is "more than an impractical academic theory... The wisdom of crowds does exist... Efficient markets are powerful, practical tools to aggregate information, and they do it more quickly and cheaply than any known alternative. In effect, the market acts like a massive supercomputer."
Chapter 2: If You're So Smart, Why Aren't You Rich?
18) On the viciousness of academia: see Sidney Morgenbesser's famous annihilation of a linguistics presentation--the presenter claimed there were no examples of double positives--when he commented "Yeah, yeah."
19) The author co-writes a finance paper showing that volatility increases nonlinearly with time, challenging assumptions about the random walk hypothesis; they get slammed by discussant who says that they must have made a programming error because otherwise there would be "huge profit opportunities in US equity markets." [Essentially this is the argument that "that can't be $100 bill on the floor because somebody would have picked it up already."]
20) Daniel Ellsberg's famous paper on risk vs uncertainty. If they are synonyms, then how can we have uncertainty about risk? See also the black and red ball thought experiment, or the "Ellsberg Paradox" (remember, this was the guy who leaked the Pentagon papers).
21) "Knightian risk" (roulette, blackjack), which can be measured, vs "Knightian uncertainty" (finding intelligent life in the universe), which can't.
22) Kahneman and Tversky and loss aversion, the author omits any mention of ensemble probability vs one-off experiments here, no mention of ergodicity, no mention of Taleb or of Ole Peters: this is really embarrassing, especially for a finance professor at MIT!!
23) Probability matching experiments: matching A to B in the ratio in which they appear; if A vs B show up 75% 25% people press A more often (but not all the time), which is (allegedly) illogical (at least from the perspective of behavioral finance academics). What you should do is just press A 100% of the time. Also other animals do this as well.
24) The "chalk" strategy for March Madness...just picking the higher ranked team. But wait, people are trying to get all the games right, aren't they?
25) "Many behavioral biases are the result of our natural human tendency to forecast and plan ahead--but applied to the wrong environment."
26) The "birthday problem."
27) Also this author could stand to read his Richard Dawkins and understand that many of the biases we have are not for us, they are for our genes, and often certain epigenetic phenomena happen so that the species can survive, even though these phenomena may be directly against the interests of specific individuals of that species. The book has one reference to Richard Dawkins on one page, on a subject that has nothing to do really with questions the author ought to be conversant in! Hasn't he read Dawkin's best-known and best-regarded book The Selfish Gene?
28) Exploring various standard fallacies: the hot hand fallacy, discrete probability, the representativeness heuristic.. interestingly, the hot hand fallacy experiments fell apart as people realized that shots in basketball are not independent events, the system is recursive, defense might tighten around that player, it turns out there is a hot hand phenomenon after all. Taleb would describe this as teaching a bird how to fly, nerdy statisticians telling elite basketball players how to play their sport!!
29) Kahneman and Tversky's behavioral finance model isn't really a theory nor was received as a model, it was too ad hoc; there was no underlying cause or hypothesis, there was no how or why explanation for it. "It takes a theory to beat a theory."
30) On academic finance's religious devotion to the dogma of EMH. See also that Lo and his co-author only discovered after their paper was published that there were was quite a bit of literature challenging the random walk theory already, including a paper by Vic Niederhoffer. Note also the author allegedly read Niederhoffer's The Education of a Speculator, but yet did not know that Niederhoffer had already published a paper challenging the random walk theory way back in 1966? Worse, note the excuse Lo gives for not knowing about this literature: "They were never included on the reading lists of any of our graduate school classes, and in those days we didn't have Google to find them." Huh??
Chapter 3: If You're So Rich, Why Aren't You Smart?
31) Helpful description here of how functional magnetic resonance imaging works (see photo); note also that the resolution of fMRI is terrible, it's even worse in real time, the activity of even a small cluster of neurons is far too small to be seen by fMRI, and finally it only shows brain activity, it doesn't show anything about actual purpose of locations in the brain except indirectly.
32) Here's what seems like an unnecessary and extended discussion of brain structure, of various neurological and brain studies, many done on rats only; the book feels a little all over the place here. There's also a lot of "studies show science" in here, and while it's interesting to think through psychology and neurology with trading and investing, depending on conclusions based on suspect "studies show science" is a problem.
33) On fear conditioning, amygdala-based learning which can be permanent with just a single event, how fear can save our lives but also can be counterproductive.
34) On dopamine and the reward system for monetary gain and its similarities to dopamine reward systems with cocaine or morphine users; losses can trigger aversion.
35) "Wired up traders": another "studies show science" study, you'll never run out of all the confounding factors here; also they divided the traders into "experienced" and "less experienced" traders, claiming that more experienced traders had lower levels of emotional arousal, again terribly confounding.
36) Note the author did one of these trader studies with Brett Steenbarger (!) in one of Linda Raschke's trader training seminars.
37) "The brain applies the same neural circuitry of fear and greed to financial experiences as it does to everything else. While money is historically ancient, it's a novelty in comparison to the length of time the human species has been on the planet. We're using our old brains to respond to new ideas." [This couple of sentences could easily been all that was necessary; two sentences could have replaced this entire chapter]
38) On hyperbolic discounting: [sheesh: another domain where behavioral finance "experts" think they've found "irrationality" among humans, while failing to understand that humans would definitely take a bird in the hand now in place of some more substantial payment in a year... when the lab, and the professor, and the entire department, and all of the silly contrived experiments might not even be around in a year! Essentially there's much more at stake than a simple discount rate, there's a type of credit risk involved here that the experimenters have no clue about.]
39) [This was the weakest chapter of the book so far, it could be boiled down to a paragraph.]
Chapter 4: The Power of Narrative
40) [This chapter could also be shrunk significantly. Who wants to hear about the Stanford marshmallow experiment again; ideas about confabulation and narrative-forming that our brains do, the old "split-brain" patients, experimental bias, or the Pygmalion effect (most of this has nothing to do with anything in the book!) these are basic psychology concepts that should be summarized much more briefly.]
41) Antonio Damasio's work with patient "Elliot"; On the role of emotion in human cognition to enable us to be rational. "In other words, to be fully rational, we need emotion." A structural challenge to the economic idea of homo economicus.
42) "Emotion is a tool for improving the efficiency with which animals--including humans--learn from their environment and their past. We're more efficient learners with emotions than without." An example would be fear conditioning, this is how we learn from financial mistakes.
43) On theory of mind in haggling, price discovery, the equilibrium price "requires an infinite chain of reasoning," and market equilibrium requires a sophisticated theory of mind and a high level of abstract thought.
44) First-order false beliefs in child development (like the Sally-Ann problem) which children can solve by around age four, versus second-order false beliefs which develop around age seven. In other words you have a theory of mind "rich enough not only to model another person's mental state, but also to model another person's model of a person's mental state."
45) Multi-order theory of mind has [catastrophic] implications for EMH; we struggle to go too many orders up the chain, the EMH would say this would get exploited away, but we can't perceive where the inefficiency would be, we can't recognize when or where the mistake is. "To put it another way, our rationality is biologically too limited for the Efficient Markets Hypothesis to hold at all times and in every possible context."
46) How we narrate our explanations and heuristics, a type of confabulation, although the author doesn't use this term. See experiments done on epileptic patients with corpus callostomies, split-brain patients studied by Roger Sperry.
47) [One thing that I can't help thinking whenever I read about these split brain experiments is it's just better in life to say "I don't know" when you don't know rather than confabulate an explanation.]
48) Humans as narrative constructing, rationalizing animals.
49) The prefrontal cortex, like the CEO of a well-run company, part of the brain's hierarchy allows it to override standard instincts when necessary: see for example Aron Ralston during his climbing accident where he amputated his own arm. See also the Stanford marshmallow experiment again [I have a sneaking feeling that this experiment is also fabricated or fraudulent in some way, but it's just a suspicion based on how many other foundational psych experiments have been exposed as fraudulent or faked.]
50) A very touching multipage story about the author's third grade teacher: as lovely as this story is... it should also be cut.
51) What is intelligence? The author argues it is "the ability to construct good narratives", or more clearly "Intelligence is the ability to generate accurate cause-and-effect descriptions of reality." [The ability to make accurate predictions might be a tighter way to say it.]
Chapter 5: The Evolution Revolution
52) Another "detour": this time through the world of evolutionary biology.
53) Lamentable to see the author cite the "peppered moth story" which has been deeply questioned and debunked: a good write-up of the controversy is here.
54) The "just so" story, various explanations about why evolution is right and competing theories are wrong; why there's no intentionality to evolution; on the nature of its selection mechanisms; the idea that natural selection can make a species so well-adapted to an environment that it doesn't survive a change to that environment; on human adaptability/flexibility and the emergence of tool-making; on nature/nurture debates and twin studies; on the development of the fields of sociobiology and evolutionary psychology; Honestly, this is all stuff that could be cut right out of the book. It's too long of a detour.
55) Exaptation: a shift in the function of a trait during evolution. For example, a trait can evolve because it served one particular function, but subsequently it may come to serve another. The human brain likely was adapted to additional functions afterward leading to further changes in development and behavior.
56) Swedish twin studies and financial outcomes: suggesting that savings and investing behavior is attributable to genetics at least in part.
57) Note that ideas can evolve too, with the key difference that they can be developed in our minds, or with other minds, and thus can evolve in much faster iterations. (Finally a genuine insight in this chapter.) This is why abstraction, language and cooperation have been so important for human success.
58) "We seem to have taken a very sharp detour [uhhh, no offense, but I think I would say a very "long" detour here] away from the world of financial markets and into the thickets of evolutionary theory. But your patience will finally be rewarded. In the next chapter, we're going to see how these ideas take on a special urgency in the financial world."
Chapter 6: The Adaptive Markets Hypothesis
59) Bank runs and panics as herding behavior.
60) Herbert Simon planting the seeds of an alternative theory in 1947 with his PhD thesis Administrative Behavior which would become the Magna Carta of the field of organizational behavior. On "Administrative Man" versus economic man; Simon popularized the word "heuristics" as how human beings navigate complex problems in their heads unconsciously, see for example chess situations. He also coined the term "satisficing"--I thought that came from Barry Schwartz's The Paradox of Choice which I've written about on my food blog Casual Kitchen. On satisficing-type decisions as an example of bounded rationality
61) On the key criticism from economists of Simon's "bounded rationality" concept: how can you know if a decision is good enough if you don't already know the optimal answer? [Just a few minutes of thought and you'll realize how stupid this pushback is, it's the sort of thing only an egghead economist would come up with. You don't need to know that optimal answer, this is literally what a heuristic is, you learn through trial and error.]
62) Learning and heuristic adjustment as a sort of conceptual evolution, but wayyy faster.
63) Finally, 185 pages into the book and (perhaps still more annoying) nine pages into the "The Adaptive Markets Hypothesis" chapter... we actually get to the adaptive markets hypothesis. (!!)
64) Individuals aren't always rational, markets aren't always efficient; humans are quirky by nature, under certain circumstances these are rational behavior-producing but in other instances are wildly irrational, their purpose "isn't economic rationality but survival." (This is his insight???) See photo for his theory in five bullet points:
66) The "tribble" example with different strategies where populations get wiped out from time to time. You also want iterative and randomizing behavior in your species just in case the environment changes, so you have a better chance to survive! Thus the "probability matching" technique that "rational economists" mock as dumb is actually the most adaptive for an iterating, changing environment. [It's strange that he sees this idea but he never mentions the concept of ensemble probability... (!) ]
67) Randomizing as a type of diversification.
68) "Our theory offers conditions that give us rationality as well as irrationality, and both could coexist for a period of time as natural selection works its magic on behavior." On idiosyncratic risk (risk faced by one individual is unrelated to risk faced by any other individual) vs systematic risk (risk affecting everyone). Where there is a systematic risk environment, randomized behavior is most successful; where there's an idiosyncratic risk environment, optimizing behavior is more successful.
69) "...we can finally begin to see how rationality and irrationality can live side by side."
70) "The history of life on Earth is filled with catastrophic events that have affected entire species at a time. Some of the catastrophes were so extreme, certain species simply couldn't adapt fast enough, and they suffered what are known as mass extinction events."
71) [Basically here you want to be not too well fitted for your environment because the environment might change faster than you can, you want to think about this from an investing standpoint! How can I be more of an all-weather investor who can recognize when the environment changes and what the implications will be.]
72) If you look at risk aversion type experiments in economics and translate them to real life you would always pick the more certain choice because this behavior would "survive" (avoid ruin or avoid extinction): "risk aversion is evolutionarily more advantageous."
73) Note also with the economist's default assumption that decisions are optimized or "maximized" (for expected utility for example), the Adaptive Markets Hypothesis doesn't say it has to be the best decision, only better than the others.
74) Note also that natural selection can exist on multiple levels: on the environment level, on the genetic level, on the market level, on an idea level, on a heuristic level, etc.
75) On how economics is cursed by physics envy; it's kind of ironic to know that economics as a profession and economists as humans are "irrational" too, in that they're trying to make their profession like a real science when it's not; the author actually calls it "theory envy" rather than physics envy because economists stay attached to their theories even though it doesn't fit the data. See also Paul Samuelson, who was one of the major drivers for the mathification of economics, a "direct intellectual evolutionary lineage" to all modern economists; thus they all have physics envy.
76) [It is interesting to think about how economics went through a very fertile period after Samuelson mathified it, but then it got ossified in the modern era into weird extreme theories like EMH.]
77) In other words the economic environment changed and became physics-based and mathified: economists had to adapt. [One way to think about this is to think of the academic environment as a selection system that selects for "approved" thought and eliminates wrongthink; we certainly see this in medicine today and it's why many academic environments function much more like religions, with heresies, heretics, outcasts, shunning, orthodoxy, etc. Samuelson's style of economics created a new intellectual or mental environment. You adapted to it or you became extinct as a PhD candidate!!]
78) "The physicist Ernest Rutherford scornfully dismissed every field that wasn't physics as mere 'stamp collecting.'"
79) Thorstein Veblen as an early evolutionary science forerunner for economics, criticizing economics for its hedonistic preconceptions, he was an outcast in his day.
80) On group selection an idea from Edward O. Wilson and Martin Nowak; thinking about evolutionary fitness taking place on a group level rather than an individual level; this might be translated to investing or business to think about firm survival, and can be further extended to any and every level of an economy in terms of competition, specialization, variation, etc.
81) On trading strategies that "feed" on market inefficiencies, but at the same time recursively affect those inefficiencies, "creating a dynamic landscape in which perfect efficiency is never achieved."
82) Other applications of dynamic evolution applied to economies, to economic thinking, Marx, Schumpeter, Soros (and his ideas about reflexivity and feedback loops), etc. On various parallels and analogies between economic and biological concepts.
83) "...the universality of the theory of evolution allows us to use biological reasoning in economic contexts. Is an investor with a failed portfolio strategy really like a great white shark flopping on the beach?" [In that it is in an environment that it's not fit for, although in another environment it might be perfectly fit.]
84) On looking at EMH as an idealized and useful abstraction rather than a fully explanatory theory.
Chapter 7: The Galapagos Islands of Finance
85) On Soros's Quantum Fund shorting the British pound in the early 90s.
86) Hedge funds as "the Galapagos Islands of finance" in that evolution happens very rapidly in this fast-moving domain of investing. [Interesting metaphor, but now we have to go through another long lecture on the finches.] On "adaptive radiation": "the proliferation of a new group of related species in a rapid burst of ecological innovation, each new species taking advantage of a different ecological strategy."
87) "Some hedge fund strategies gain while other strategies lose, and in the background, there's a constant process of hedge fund formation, innovation, and extinction."
88) The author shares an amusing and sarcastically accurate definition of a hedge fund as a private partnership where "at the start, the general partner brings all the experience and limited partners bring all the money. At the end, the general partner leaves with all the money and the limited partners leave with all the experience." Good one.
89) One of the author's academic finance colleagues asked him about the collapse of Long Term Capital Management: "Isn't this just a case of a bunch of rich guys losing their money--who cares?" [One can't help thinking duh, you should care! That is, if you want to be competent in understanding finance.]
90) Alfred Winslow Jones as one of the early long/short hedge fund managers in 1949; predating him was Ben Graham who ran a private investing partnership in the mid-1920s. The explosion of hedge funds in the 1960s and then an extinction event in the 1969 market correction.
91) On Buffett's famous article "The Superinvestors of Graham and Doddsville."
92) On the rise of quants, another example of "a burst of adaptive radiation", starting with Morgan Stanley's "electronic trade analysis and processing system," then when David Shaw left Morgan Stanley to form D.E. Shaw, using mathematical techniques to identify arbitrage and trading opportunities and market anomalies; per Sshaw, the "effects tended to disappear over time."
93) Long Term Capital Management; their infamous heavily-levered bet on the convergence of rates and credit spreads globally, which blew apart when Yeltsin's Russia defaulted on its debt. The author describes it as a keystone species in a biological ecosystem.
94) The "clandestine competition" in markets where investors discovering anomalies and exploitable opportunities compete with academics claiming that markets are efficient--and yet these investors actually are making the market more efficient! Oh gosh the irony.
95) On the arc of high frequency trading, from profitable to extremely low profit as competition and the technological arms race increased.
96) Fisherman in Kerala India: where fish markets became much more efficient when cell phones were available and usable out at sea.
Chapter 8: Adaptive Markets in Action
97) First review of the core beliefs of EMH
1) There's a risk reward trade off
2) Alpha, beta (William sharpe's idiosyncratic versus systematic risk) and CAPM as a pointy headed framework for the relationship between risk and reward
3) Portfolio optimization and passive investing works very well
4) Asset allocation is more important than security selection
5) Investors should hold stocks for the long run
98) Implicit assumptions of EMH: the statistical properties of asset returns don't change over time (wrong), the statistical relationship between return and risk is linear (nope--it isn't), and stays the same over time (it doesn't), investors are rational (they aren't), and markets are efficient (they're not).
99) On the great modulation, from the middle late 30s to the late 90s versus the last 20 years where markets are larger and stranger. There are many more people, many more wealthy economies, many more drivers to market ups and downs, also an increasingly unstable relationship between risk and return.
100) Here he uses his adaptive markets hypothesis to explain that increases in equity volatility cause investors to reduce holdings through a fight-or-flight response or freaking out; this is a perfect example of a just-so story.
101) Deregulation of the brokerage industry, leading to discount brokerage firms being founded, the deregulation happened May 1st 1975. Prior to this there were fixed commissions of 2% or more for standard brokerage charges.
102) What makes for a useful, good index? What do we want out of an index? Easy information about the market return, a standard against which active management can be compared, and then something that's investable.
103) A new ecosystem of a wide range of index products of different styles and conditions.
104) The author posits an actively managed index fund that would scale in and out of the market based on market volatility on a rolling window of 125 days, putting equity exposure as high as 130%, using a little bit of leverage, but taking it down if volatility goes above some level. He calls it a "volatility cruise control" strategy. [The problem here of course is this volatility measure is backward looking!] The author claims this reduces the exposure to kurtosis in the stock market (kurtosis is a measure of fat-tailedness, or outlier frequency that defies the norms of a normal distribution).
105) What does the Adaptive markets hypothesis have to say about the question "Can I beat the market?" First, it depends on who you are, second you have to be iterative and move from one good strategy to another to maintain outperformance, you need to adapt. See Victor Neiderhofer's book The Education of a Speculator where he talks about herbivores or dealers, carnivores, large speculators and decomposers, floor traders and bankruptcy investors.
106) The idea that the efficiency of a market changes, it's a variable or it's on a continuum, and that this "efficiency" can be measured.
107) On how the random walk hypothesis was wrong or didn't hold for extended periods of stock market history, where the autocorrelation of returns from one day to the next were significantly positive then significantly negative. The EMH doesn't even allow us to pose the question why this happened. One driver might have been May Day, the May 1st 1975 elimination of fixed rate commissions, leading to a democratization of markets.
108) The quant meltdown of August 2007, the author receives calls from three different former students working at statistical arbitrage hedge funds, all asking "What's going on with other hedge funds?" [Why would they call their professor rather than somebody who was actually in that world, following what's going on?] "Some unknown financial phenomenon was inflicting record losses on a specific group of hedge funds, funds that were so highly adapted to their existing environment that they were unprepared for the shock." A 25 standard deviation event several days in a row. What happened was a "liquidity spiral" per this author [but likely really what happened was just somebody got liquidated; too many firms had the same longs and shorts creating a huge crowded trade. This entire multi-page discussion on that meltdown could be replaced with a short sentence: "somebody got liquidated."]
Chapter 9: Fear, Greed, and Financial Crisis
109) "No new theory of financial markets should be taken seriously unless it has something useful to say about the financial crisis of 2008... After all, the near-collapse of the global financial system hardly looks rational or efficient." [Note that we could say this about 1987, 1969, 1939, etc.]
110) The financial system is an ecosystem; we want to accurately model the behavior of the key species in that system.
111) Examples of financial evolution in the form of adaptive radiation of new mortgage types, as well as securitizations of those assets. Also many more participants in this marketplace plus the credit default swap.
112) The author is a little shaky on some of the participants in this ecosystem: he confuses AIG's role with Ambac and MBIA... It's also funny hearing him narrate this, post-dicting a lot of the things that happened... to quote the author's own chapter title from earlier in the book: "if you're so smart why aren't you rich?"
113) The financial crisis as a Rashomon event: everyone's perspective is significantly different. The author then lists certain popular narratives of the crisis "that may not be as accurate as they sound": Big bonuses/not enough skin in the game; regulators asleep at the wheel; etc. The author maps how some of these mistaken narratives bled into various books and articles about the crisis; note for example the discussion on the SEC rule 15c3-1 (the net capital rule for capital requirements at broker-dealers), a rule that was modified in 2004: there was a false narrative here that spread and was repeated throughout the media about how this "allowed" broker-dealers to over-lever, which was not true, also those leverage levels were known and in public filings anyway. Further, these firms had been running very high debt to assets ratios since the 1990s, long before this rule change allegedly changed the rules.
114) On why falsehoods like this travel so easily, based on humans need to use narrative to explain the world, we also have biases towards specific kinds of narratives like "the good guy wins"; see William James who said people believe narratives are true because they are useful to them.
115) Could we have avoided the crisis? The book is again adrift here from its topic.
116) Various comments about hedge funds and how they operate, unfortunately it's clear he doesn't really know that much about that space when he claims when a hedge fund strategy gets too crowded "this is precisely the point where hedge funds will try to use leverage to increase their profits." How can we know this? It's more likely when a trade gets crowded people tend to leave the trade.
117) The author wonders why nobody listened to the people calling for a crisis, nobody listened to warnings about the system. Note the fallacy here: it's a form of survivor bias to wonder why nobody listened to the "calls for a crisis" because there are always, always pundits calling for a crisis. Most of these calls are wrong! What happens when there is a crisis we know there was a crisis (obviously), so everybody goes back and looks back who "called" for it! This is the Elaine Garzarelli problem, basically (she "called' the 1987 crisis--almost certainly due to luck--and thereafter never distinguished herself in any way as an investor or a pundit ever again). Also, one can't help asking, again: if this author is so smart to expect a crisis to be "seen" and "called form" why wasn't he in there with Michael Burry shorting everything?
118) I think if the author had read his Hyman Minsky he also would know that he's borrowing Minsky's idea of how humans, during a prolonged absence of accidents/losses, start to seriously underestimate the true amount of risk; this is basically what Minsky meant when he famously said "stability is destabilizing!" Unfortunately none of Minsky's work is cited anywhere in this book--a major oversight.
119) Misspelling here of Beazer ("Bezear") Homes, the homebuilder, on page 325. It's suspect when a mistake like this appears: granted, it could be just an innocent typo, but this is a well-known homebuilder stock, it implies that this academic may not know the stock market quite as well as he thinks he does.
120) Comments on decimalization, which (supposedly) had a second-order effect of hurting liquidity; I'm not sure if this is actually true but it is plausible. I don't think the author fully understands decimalization though, the fact that stocks trade in decimals (rather than in eighths or 16ths of a dollar like they used to) doesn't mean necessarily that spreads are tighter!! It's not like all stocks trade with a spread of one penny now...
121) This was one of the more boring chapters of the book.
Chapter 10: Finance Behaving Badly
122) Bernie Madoff and his gift for "affinity fraud" fucking over the people who had a personal connection to him.
123) The "ultimatum game" where people reject free money in the spirit of fair play.
124) From Madoff to the neuroscience of morality... this chapter is not organized particularly well and is not well-tied to the book's overall theme.
125) "Our moral intuition about fairness simply isn't fully adapted to the world of modern finance. In fact, under the Adaptive Markets Hypothesis, it would be surprising if it were. Financial markets have been around for only a few thousand years, a blink of an eye in human evolutionary time scales." [Think of this like translating the ideas behind the paleo diet to the domain of money/investing]
126) The author also has a very orthodox and establishment-approved impression of the so-called wildcat banking era, he ought to look up some Bitcoin-related monetary history for literature on Scotland's wildcat banking era to understand how it can be done properly.
127) Somehow I knew the Milgram experiments were going to show up here.. the author doesn't know they've been debunked. Likewise the Stanford Prison experiments--he doesn't know. Jeez.
128) On the SEC really blowing it with Madoff: they received six (six!) separate, credible, incoming reports on him and ignored them all. [If anything the SEC is even more incompetent now than then, despite the author's (appropriately tentative) assertions to the opposite. Also I can't help thinking if regulatory and cultural changes evolve at the speed of thought per this author why did it take freaking ten years to catch Madoff?]
129) The author is quite a bit out of his element when he's trying to talk about problems of complexity in the modern financial system and I shudder to think about the next chapter which talks about fixing finance.
Chapter 11: Fixing Finance
130) "Human behavior adapts to various environments" thus "we're much more likely to develop accurate narratives for guiding our responses to crises."
131) [Unfortunately the author foolishly defaults here to centralization-related solutions: calling for government solutions to various problems and risks in the stock market; I don't think he sees the structural problem of centralization at all. As I read, I have the same sinking feeling I had when reading Erich Fromm's Escape From Freedom where he warned of creeping totalitarianism all over the world, yet his solutions for it involved a centralized bureaucracy! It's actually quite disturbing to read through Fromm's insightful and perceptive book, only to find that at the end the author believes the conditions of society to enable freedom require a planned economy. It makes you want to reach through the book, shake the author by the scruff of his neck, and shout at him, "How can you see the problem so clearly and yet schlump back into the very solution that brings about your original problem?" I felt precisely the same way when Dr. Lo calls for a centralized information clearinghouse for crisis information during financial panics.]
132) In the same vein: It's nice to apply ecology to financial regulation, that's a great idea--but the whole problem is that you have centralized bureaucrats performing the regulation.
133) Examples of effective regulatory mechanisms involving thermal homeostasis-type feedback loops: central bank interest rate policy; see other proposed ideas like counter-cyclical capital buffers; see the Chicago Merc's regulatory systems for example; the author wants to apply these types of rules "to the entire financial system."
134) [The author does not see the tremendously arrogant epistemic error here.] "Rather than simply mandating that commercial banks and insurance companies can't be bigger than a certain size, we should first understand what the optimal size of an institution is given the current business environment. Then we can devise a more effective and sustainable regulatory mechanism for managing the growth of these important organizations, like adapting the upper limit on firm size to match business conditions and potential threats to financial stability."
135) Law as a type of adaptive system, one that adapts very slowly and wasn't designed for periods of rapid change.
136) Modelling contagion by measuring "interrelatedness" [this author thinks it's "astonishing" to discover that during panics or market crashes correlations approach 1. Yet again, academics teaching birds how to fly... ]
137) The author compares the interrelatedness of international markets the day before the Brexit vote and then again three days later, finding much more dense and interrelated connections after. But what exactly does this prove? Brexit actually de-interrelates the system, it's just that the surprise factor of this vote was what caused much more movement of capital after the surprise occured. What's the value of looking at this three days later and drawing any conclusion at all?
138) At this point the book is really starting to get all over the place: the author writes coherent sentences but a lot of it is word salad, talking about regulatory policy that he only partially understands. See for example his discussion of "the gift of pain" (in the sense of burning your hand on the stove and thus learning) as something the financial system is lacking.
139) The author wants to create an NTSB/National Transportation Safety Board-type organization for the financial system so we can analyze market crashes just like plane crashes. [This is his idea? One thing interesting at least is how the NTSB has no regulatory authority, which means it can't be "captured" as easily as typical regulatory bodies (see the FDA, defense industry, etc).]
140) Periodically there are sentences in here where the author really betrays his ignorance of the financial world, of the real financial world. "How many financial calamities could be prevented, or their impact reduced, if there was an official clearing house for crisis information beyond Bloomberg terminals and Twitter?"
141) The book is becoming increasingly impracticable and unreadable at this point: general policy recommendations and predictions are really quite pointless for a book like this. The author wants to build better quantitative models, but he has ideas that will be quickly gamed by the very adaptive system that he just wrote an entire book about. There's another horrible example in here of using a statistical calculation of the "risk appetite" of a financial executive using a mathematical formula, then modelling each executive to arrive at a measure of "financial culture" quantitatively. This is his idea of understanding and controlling "the Gekko effect" (as in Gordon Gekko).
142) He trusts a centralized/federalized financial information clearing house, but also trusts that it will protect our privacy and anonymity.
143) He cites the "friendly and productive" relationship between Dutch bank regulators and the Dutch financial industry as something to look up to... while completely leaving out (as just one painfully important example) ING Bank's (one of the Netherlands' largest banks) money-laundering activities, its 2008 failure and resulting need for a tremendous bailout and capital injection from the Dutch government.
Chapter 12: To Boldly Go Where No Financier has Gone Before
144) The author cites how much inspiration he got from the original Star Trek show, an experience many of us shares--at least until you think about the form of government (a literally totalitarian government!) that runs this future utopia: In Star Trek, the State owns everything, the State decides everything, the State provides everything, and ironically, all the people in the future will own nothing and you will be happy. It's almost like Roddenberry anticipated the WEF!
145) The last three chapters should have been cut: it would have improved the quality of the book.
To Read:
Benoit Mandelbrot: The Fractal Geometry of Nature
Daniel Ellsberg: The Doomsday Machine: Confessions of a Nuclear War Planner
Daniel Ellsberg's famous paper "The Art of Coercion"
Daniel Ellsberg' paper: "Risk, Ambiguity, and the Savage Axiom"
***Frank Knight: Risk, Uncertainty and Profit
Gerd Giggerenzer: Simply Rational: Decision Making in the Real World
Thomas A. Bass: The Eudaemonic Pie
Thomas A. Bass: The Predictors
***Tom Wells: Wild Man: The Life and Times of Daniel Ellsberg
***Natasha Dow Schüll: Addiction By Design: Machine Gambling in Las Vegas
Antonio Damasio: Descartes' Error
***Michael Gazzaniga: Human
Ian Tattersall: Becoming Human
Jeff Hawkins and Sandra Blakeslee: On Intelligence
Edward O. Wilson: The Insect Societies
Edward O. Wilson: Sociobiology: The New Synthesis
***Herbert Simon: Administrative Behavior
***Herbert Simon: Models of My Life
Eric D. Beinhocker: The Origin of Wealth: Evolution, Complexity and the Radical Remaking of Economics
George Soros: The Alchemy of Finance
Sebastian Mallaby: More Money than God: Hedge Funds and the Making of a New Elite
Jonathan Weiner: The Beak of the Finch: A story of Evolution in Our Time
Peter R. Grant and B. Rosemary Grant: How and Why Species Multiply: The Radiation of Darwin's Finches
Tom Wolfe: The Bonfire of the Vanities
Andrew Lo: "Reading About the Financial Crisis: A Twenty-One-Book Review" (paper) [PDF here]
Carmen Reinhart and Ken Rogoff: This Time Is Different
Charles Perrow: Normal Accidents: Living with High-Risk Technologies
Terry Burnham: Mean Genes
Roberta E. Pearson and Maire Messenger Davies: Star Trek and American Television