Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Ho. Princeton University Press (Princeton and Oxford), 2017, First Edition; 483 pages; £31.95
Since the financial crises of 2008, the workings of financial markets and its participants (namely, big banks, traders, hedge funds, regulators, private equity firms, etc) have become an area of greater interest to general readers. While optically in the same genre, the book under review has a broader aim. Based on concepts of evolutionary theory, it proposes adaptive market hypothesis as a candidate theory to explain a range of market behaviour, including the so called irrational aspects of it. Its scope includes working of financial markets and its various participants over a longer time frame than simply a run up to financial crises of 2008. The author, Andrew Lo, is MIT professor and Director of the MIT Laboratory on Financial Engineering. The book was shortlisted for FT/ McKinsey Business Book of the Year 2017.
The author proposes that the behaviour of financial firms is subject to evolutionary influences, such as natural selection, pursuit of survival goal, mutation, and adaptation (or extinction) in response to environmental change – and hence the name “Adaptive Markets”. The author develops the adaptive market hypothesis by looking at how economic thinking on financial markets has progressed mainly since World War II. In doing so, the book presents a rich and engaging narrative of various epoch points in the history of economics (with emphasis on financial economic) including how economics became highly mathematical (and dominated by Quants) and the supremacy of Efficient Market Hypothesis (EMH). The author questions the economic rationality and utility maximisation assumptions made by economists in their models, and presents research findings, which while not new to an interested reader in this field, still manage to engage the reader. The book sheds light as to how Efficient Market Hypothesis (EMH) became mainstream in financial economics and critiques its near universal appeal and application. The book contains examples where EMH has explained a phenomenon (such as Space Shuttle challenger tragedy of Jan 1986, where the loss of market capitalization for one of the firms almost equalled the loss firm suffered) and examples where it did not (such as market bubbles and crashes). Since the book analyses the working of financial markets, technical concepts such as alpha and beta, passive investing and Capital Asset Pricing Model are explained in simple terms to a non-financial reader.
The author argues that the financial markets show both “wisdom of crowds” (rational behaviour) and “madness of crowds” (so called irrational behaviour) at different points in time, because the participants (such as traders, regulators, and hedge fund managers) and markets are a product of evolutionary process and adapt through a process of mutation and selection to the evolutionary forces at work. In the case of participants, these evolutionary forces include fear vs. flight response and behavioural biases (example: loss aversion) that have shaped human behaviour since the evolution began. In the case of markets, examples of evolutionary forces include changes in technology, new regulations, and evolution of quantitative and high frequency trading. The author suggests that so-called “irrational” aspects of market behaviour are expected and/or normal behaviours from an evolutionary perspective. Adaptive market hypothesis seeks to integrate both rational and irrational aspects into one framework to explain the behaviour of financial markets in a holistic way. In the last few chapters of the book, author outlines his views on 2008 financial crises, fixing finance, and how the potential of finance – and financial engineering – can be used to fund the pursuit of solutions for some of the serious challenges facing us now, such as cure for cancer and climate change.
From the perspective of a non-finance reader, there is a good deal to commend about this book: The range of perspectives explored and concepts explained are remarkable. Research findings are appropriately caveated and conflicting perspectives, which challenge the findings, are presented where needed. Interestingly, for a book that uses concepts from fields as diverse as economics, neuroscience, psychology, behavioural science, game theory and evolutionary theory, it is well integrated and does not give the sense that the material is not relevant to the narrative. Given that main research findings in behavioural economics and neurology/brain sciences have already appeared in many books in the last few years, it makes it difficult for any new book to keep a reader interested in the narrative while presenting the same insights one more time. This book manages to do it, mainly because it draws from broader range of fields, provides historical context and contains rich anecdotes. While a general reader is likely to find value in the range of perspectives covered from different fields in social and natural sciences, particularly because these insights can be applied to their own disciplines as well, it is likely that a reader looking for a technical treatment of the subject may find them a bit digressive and redundant.
The challenge with evolutionary theory is that it is hard to find any dynamic eco-system which is not influenced and whose behaviour can’t be partly explained – often retrospectively –using evolutionary concepts. Therefore, while its application to financial markets is an important first step, there is not enough material on how it can be used to influence financial market behaviour on a pro-active basis. If, as evolutionary theory argues, one of the main goals of species is survival – and it is hard-wired into the brain – then there should be ample choices available to regulators and firms to make it easier for participants to survive if they show right kinds of behaviour – or hard to survive, if they practice undesirable behaviours. Given that financial firms and regulators are still struggling after nearly 10 years of financial crises to get right behaviours implemented, more analysis would have added strength. It is probable that once research shows how the evolutionary concepts can be used to encourage “right” market behaviours, the nature of markets would have changed because of crypto-currencies, block chains, alternate data analysis and other large and unpredictable events. This brings up another challenge to evolutionary theory as applied to financial markets, i.e., unexpected disruptive big events happen more frequently than they do in the nature itself, and while adaptive market hypothesis can explain them, currently we are still short on insights on how to influence such “eco-systems” on a proactive basis. These observations do not diminish the strength and value of the book, and given the nascent nature of field, there is only limited material available currently, which the author has covered well.
If the aim of the book was to prove that Efficient Market Hypothesis does not always apply and has its’ limitations, and that financial markets are not always rational, then the book succeeds to a remarkable extent. However, if the aim was to suggest Adaptive Market hypothesis (using evolutionary concepts) as a leading candidate theory to explain the market behaviour, then the arguments presented in the book indicate its’ potential, but more research and a framework is needed to achieve it. To summarise, this is an excellent book with a comprehensive range of ideas, historical narrative and a different lens to look at financial markets. There is a lot to reflect and apply from this book for readers from different disciplines and backgrounds.
