Ever since I was a graduate student in economics, I’ve been struggling with the uncomfortable observation that economic theories often don’t seem to work in practice. That goes for that most influential economic theory, the Efficient Markets Hypothesis, which holds that investors are rational decision makers and market prices fully reflect all available information, that is, the “wisdom of crowds.”
Certainly, the principles of Efficient Markets are an excellent approximation to reality during normal business environments. It is one of the most useful, powerful, and beautiful pieces of economic reasoning that economists have ever proposed. It has saved generations of portfolio managers from bad investment decisions, democratizing finance along the way through passive investment vehicles like index funds.
Then came the Financial Crisis of 2008; the “wisdom of crowds” was replaced by the “madness of mobs.” Investors reacted emotionally and instinctively in response to extreme business environments — good or bad — leading either to irrational exuberance or panic selling.
Behavioral economists — who believe that investors are irrational and market prices are driven by fear and greed like so many other species of mammals — took a look at the crisis and said, “Told you so.”
I think about these two schools of economic thought like arguing parents: You just wish they would stop fighting and get along because you love them both and don’t want to take sides. I grew up with both schools and they each have some compelling arguments, but neither is complete by itself.
Rather than just criticizing existing theories, I decided to develop an alternative, which I call the Adaptive Markets Hypothesis, a framework that applies evolutionary biology to financial markets. This hypothesis reconciles the two schools by providing a broader framework in which both those hypotheses can live happily together in a mutually consistent way.
The Adaptive Markets Hypothesis, examined in my book, Adaptive Markets: Financial Evolution at the Speed of Thought, draws on recent research in psychology, neuroscience, evolutionary biology, and artificial intelligence, to show that human behavior is the result of several components of the brain, some of which produce rational behavior while others produce more instinctive emotional behavior. These components often work together, but occasionally they compete with each other. For evolutionary reasons, rationality can be trumped by emotion and instinct when we’re confronted with extreme circumstances like physical threats — we “freak out.” And that affects markets.
Read the full post at MarketWatch.
Andrew Lo is the Charles E. and Susan T. Harris Professor, a Professor of Finance, and the Director of the Laboratory for Financial Engineering at the MIT Sloan School of Management.