Adaptive markets theory by Andrew Lo

I attended a public lecture today by Andrew Lo. The talk is about adaptive markets theory, based on his recent published book called Adaptive Markets: Financial Evolution at the Speed of Thought. 


The best part about this talk is that it is not just about the theory. It is a story of how Andrew Lo himself came about developing this theory and subsequently writing this book, after 2 decades of research. I personally think Andrew Lo is an excellent speaker. He has his own charisma and for every of his lecture that I attended, he never failed to inspire me. When you go for Andrew Lo’s classes or public lecture, sometimes it is not about the theory that you want to learn, it is his philosophical of life and finance that you want to bring back with you – something that you can never get in a book or anywhere else.

The book was supposed to be published in 2008. But due to the financial crisis, Andrew Lo felt that his adaptive markets theory needed an update. So he went on a quest of more research and finally published it this year.

For someone who came a finance background, I can relate to the theory which I entirely agree with it. Adaptive markets theory aims to reconcile the theory of efficient markets hypothesis such that share prices always reflect all relevant information and that no one can outperform the market, with behavioral economics. We are now operating in adaptive markets, more so than before as the markets change constantly and more frequently, mainly due to the actions of people.

Theory aside, what I found inspiring about his talk was his own personal story about how he was claimed to have a mental disorder by his mom (not in a bad way) because unlike other Asians who we often stereotype as good in Maths, Andrew Lo was not. He excelled in all subjects especially science but Maths. His turning point was when at 3rd grade, his maths teacher made him believe that he was good at something and that he just needed to find it. His teacher introduced him to abstract maths and to his surprise, he was very good at it. And that’s when he found his niche.

To his point, adaptive markets theory is essentially that. When your narrative changes, your outcome will change too due to the change in your behaviour and belief. Once I am done with George Doriot’s book, this book is going to be the next on my list.

Some other key takeaways from today’s talk are as follows:

  • Traditional investment framework is flawed (not wrong, but incomplete)
  • Efficient market hypothesis works in stable environment
  • Adaptive markets – manage risk via active volatility scaling algorithms
  • Alphas is multiple betas
  • Markets adapt through the actions of people
  • Adaptation can be counterproductive especially if we think the risk is lower (where in fact it is actually the same)
  • Why machine learning is important in finance: Need to collect and process more data to have more in grained, refined and detailed information to understand and make better decisions (analogy: high resolution pic, the more pixels the better)
  • But can lead to some stereotypes and biases – racism, sexism
  • When someone tells you that you can’t do it, learn as much as can from them, but don’t believe in what they say because they don’t understand you as much as you do although they think they know you. Once you believe in it, ie once you change your narrative, your positive energy and motivation will propel and lead you to success that you dream of
  • Evolution is a process of elimination, it may be a good thing or a bad thing
  • Artificial intelligence can create new stories as a function of market conditions and environment that is changing and as the market adapts
  • Need regulations that are adaptive before the fact
  • Persistence pays off
  • We need collective intelligence and wisdom of crowd

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