Adaptive Markets: Financial Evolution at the Speed of Thought

by Andrew W. Lo

have you ever heard of James Simons? In 1988, this former professor started a fund trading futures using his own mathematical models. In its first eleven years, Simons’s Medallion Fund racked up a 2,478.8 percent net return, or 34.4 percent a year, and it kept up the pace thereafter. The fund was closed to new investments after that point, so less is known of its subsequent performance, but in 2016, Forbes estimated Simons to be worth $15.5 billion, having made $1.5 billion in 2015. Simons didn’t get rich investing in index funds.

Malthus forecast that human population growth would increase exponentially, while food supplies would increase only along a straight line. He concluded that the human race was doomed to eventual starvation and possible extinction.

This Jekyll-and-Hyde personality of financial markets, oscillating between wisdom and madness, isn’t a pathology. It’s simply a reflection of human nature.

Liber de Ludo Aleae (The Book of Games of Chance),

Fama summarized his version of the Efficient Markets Hypothesis in an epigram that became famous: in an efficient market, “prices fully reflect all available information.”

a longstanding relationship between unemployment and inflation known as the Phillips curve.

The Phillips curve suggested to most policymakers that government policies that reduce unemployment do so at the cost of increasing inflation, and government policies that reduce inflation do so at the cost of increasing unemployment. Adjust one, and the other becomes an issue.

The wisdom of crowds depends on the errors of individual investors canceling each other out. But if we all exhibit certain behavioral patterns that are consistently irrational in the same way, sometimes the errors don’t cancel out.

Ellsberg Paradox, after the example in Ellsberg’s seminal paper. Thinking isn’t the same as feeling. You can think the two games have equal odds, but you just don’t feel the same about them.

Human nature simply doesn’t allow us to view uncertainty with indifference. Fortune favors the brave, and market prices reflect our innate tendency to avoid uncertainty.

Guy Laliberté and the professional gambler David Benyamine created a pot of $1,227,900

The first thing a junior trader learns is to “cut your losses and ride your gains.” In other words, in the face of losses, fight the tendency to be too risk-seeking; and in the face of gains, fight the tendency to be too risk averse. This sounds like simple advice, but it’s surprisingly hard to follow,

Loss aversion applies not only to traders and investors, but to any individual facing a choice between a sure loss and a riskier alternative that may bring redemption.

many behavioral biases are the result of our natural human tendency to forecast and plan ahead—but applied to the wrong environment.

Why do people find order within random patterns? They unthinkingly take a small sample as representative of the whole, using the representativeness heuristic. In other words, they’re misled by their limited data to make an incorrect prediction.

being an enfant terrible in academia, as a career strategy it’s quite risky. After all, as they get older, enfants terribles often become just terrible.

While all traders, including the most experienced, reacted to significant market moves, we found that the less experienced traders were physiologically more sensitive to these short-term changes in the market. Moreover, in the aftermath of these extreme market moves, the emotional arousal of more experienced traders quickly returned to normal, whereas the less experienced traders showed higher levels of emotional arousal that lasted much longer.

Traders who described more intense reactions to both losing and making money performed significantly worse than others.

those who scored higher on a measure of “internality”—the tendency to ascribe the causes of various events in their lives to their own doing versus random chance—also performed much worse than those who scored lower on this scale. These patterns tell us something about the stuff good traders are made of: more controlled emotional responses, including the ability to refrain from blaming (or lauding) oneself too much for trading outcomes.

If you take losses and gains to heart too much, attributing your daily profits and losses to your own devices rather than good or bad luck, you quickly burn out and become incapable of making sound financial decisions.

The brain applies the same neural circuitry of fear and greed to financial experiences as it does to everything else.

we’re more impulsive over the short term and more logical over the long term,

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.

the prefrontal cortex is subject to biological limitations. As impressive and unique as it is, it can’t operate instantaneously or indefinitely. It can’t multitask very well, contrary to popular belief and desire.

Intelligence is the ability to generate accurate cause-and-effect descriptions of reality.

In his book, On Intelligence, Hawkins argues that intelligence consists of two features: memory and prediction. Most of the human brain, Hawkins believes, is devoted to these two activities.

Biston betularia f. carbonaria (see figure 5.1b in the color section). The first instance of this mutation was collected in the British industrial city of Manchester in 1848. Within a few decades, they were widespread in the area. In a hundred years, they were the most common type of peppered moth in northern England.

As Woody Allen put it, “80 percent of success is just showing up.”

Proconsul, an African primate that’s considered one of the first apes, lived 25 million years ago.

the religious sect known as the Shakers. Formed in eighteenth-century Britain around a charismatic female prophet, Ann Lee, the Shakers eventually migrated to the United States, first settling in New York and then spreading up and down the East Coast and as far west as Indiana. Focused on purity, the Shakers became known for the clean design of their furniture, for the quality of their herbal medicine, and for the simplicity of their food and music. However, the Shaker religion is nearly extinct today, and for a simple reason: Mother Lee expected her adherents to remain celibate all their lives. Shakers could only increase through conversion or adoption. With only a handful of adherents left, the Shakers have vanished almost as completely as the dodo.

glucose can reverse the effects of decision fatigue.

it’s the ongoing exchange of ideas that ultimately leads us to the answer, and this too is an evolutionary process. Natural selection applies to narratives as well as to genes. In

the eugenics movement. This movement, not very well known today, tried using political power to eliminate “defective” individuals from the population’s gene pool, often through involuntary sterilizations. Many American states passed statutes for the sterilization of the “unfit,” often including the poor, the imprisoned, and the mentally retarded. While these laws sound offensive and wildly illegal to modern ears, for decades these laws were upheld by the Supreme Court.

Individuals didn’t optimize—they satisficed, making decisions that weren’t always optimal, but were good enough. Simon called this theory bounded rationality.

When nature acts randomly, the species that tend to survive are those with behaviors that are randomized to counteract the risk posed by nature. The behaviors that tend to do best are those in which the risks are hedged most effectively, as in the case of probability matching. In other words, to borrow a phrase from physics, nature abhors an undiversified bet.

the beautiful simplicity of Newtonian physics has intractable difficulties with systems of more than two elements, as in the three-body problem of classical mechanics.

the fluctuations of an investment’s return can be separated into two distinct components: fluctuations due solely to the unique characteristics of the asset, and fluctuations due to economywide factors like economic growth, unemployment, inflation, political instability, and so on. He called the former kind of risk “idiosyncratic” and the latter kind “systematic”

Historically, the market risk premium has been around 8 percent above the rate of return on U.S. Treasury bills per year, although most forecasts and finance professionals now say that this risk premium is likely to be closer to 6 percent going forward.

Financial journalists later dubbed what was happening the “Quant Meltdown” of August 2007. Some unknown financial phenomenon was inflicting record losses on a specific group of hedge funds,

“There is no hope of explaining home prices solely in terms of population, building costs or interest rates. None of these can explain the ‘rocket taking off’ effect starting around 1998.… The changing behavior of home prices is a sign of changing public impressions of the value of property and of a heightened attention to speculative price movements. It is a sign of a bubble, and bubbles carry within them the causes of their ultimate destruction.”

In 1965—three years before he cofounded Intel, now the largest semiconductor chip manufacturer in the world—Gordon Moore published an article in Electronics Magazine in which he observed that the number of transistors that could be placed onto a chip seemed to double every year.