Adaptive Markets by Andrew W. Lo [Book Summary]

Even if you’ve haven’t invested any money in stocks or bonds before, your life is still affected by the market. If you were searching for work in the aftermath of the 2008 financial crisis, you understand precisely how dependent banks and normal businesses are on a healthy economy. Therefore, it is reasonable to hold at least a simple knowledge of how things function– and that’s precisely what these chapters offer.

You’ll discover the dominant ideas concerning the stock market and the new ideas the author has suggested how things can get better. There’s no cause why something as powerful as present’s financial system has to be stuck in an ancient approach of doing things; it’s time we began thinking big and setting the system to function for the benefit of the entire world!

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Chapter 1 – The Efficient Market Hypothesis is the most commonly recognized theory for how the market functions.

If you’ve done an Economics 101 course, you’ve most likely heard about the predominant theory about how the market functions: the Efficient Market Hypothesis, or EMH in short.

Briefly, EMH theory suggests that the price of stocks, bonds, and similar investment assets will continuously give a precise reflection of the health, profitability and general value of a firm.

In present years, it’s become commonly recognized that the EMH isn’t perfect; however, academics and top experts in the investment industry still see it as the best theory present.

To understand how the EMH works, let’s consider the company Morton Thiokol, which assisted create rockets for NASA in the 1980s, as well as the defective piece of equipment that was discovered to be the cause of the  Challenger Space Shuttle explosion in 1986. It made perfect sense that the value of Morton Thiokol shares fell in the minutes after the Challenger disaster because the company had only faced a serious obstacle.

The EMH functions because it takes into consideration the collective wisdom of the whole investors who are always studying the market and showing their best assessments of how efficient businesses will perform in the price they’re keen to buy and sell their assets at. It’s commonly accepted that by combining all these active financial minds, you’ll get a fairly correct reflection of a company’s value.

Now, given this high respect for the EMH’s precision, it is also viewed very unlikely that anyone can “beat the market,” which would comprise noticing something that every other person didn’t see. So, because you can’t beat the market, the typical recommendation is to “join the market” by investing in long-term, low-risk index funds, or mutual funds, which involve a group of stocks that will stay more or less untouched gradually.

By continuing with index funds for a long time, a patient investor can assume to make the most of the stock market’s steady increase in value gradually. It was these standard principles of EMH that made John Bogle establish the Vanguard Index Trust, the first-ever mutual fund that was created in 1976.

From that point, the index and mutual fund businesses have become a multi-trillion-dollar staple of the finance business.

Chapter 2 – The Adaptive Market Hypothesis takes into consideration the human component of finance.

You might be wondering if the Efficient Market Hypothesis is really correct and simple, why do massive financial crises where assets are totally misvalued, such as the one in 2008, keep occurring?

The answer to this question lies in human nature and the fact that those in charge of the market are susceptible to making choices based on irrational feelings. Therefore, even if a company is by all ways healthy, if the price of its stock takes a momentary dip, this can initiate a panicked reaction among traders concerned about losing a lot of money and, in turn, will make them sell. This is called behavioral economics.

So, what we require is a model that takes into consideration both the logical rules of EMH and the illogical rules of human nature, which is precisely what the Adaptive Market Hypothesis does.

Basically, the Adaptive Market Hypothesis views the market from an evolutionary perspective to know that everything occurs for a purpose. For instance, when John Bogle presented a new feature to the Vanguard Index Trust called the market-cap-weighted indexes, this was a reaction to increased rivalry and a means for Bogle’s mutual fund to need even less job from portfolio managers.

Because mutual funds using Bogle’s new feature need less oversight, they require less time and cost to sustain, which in turn makes them really charming to investors. Therefore, if we view market-cap-weighted indexes from the lens of evolution, it’s not surprising that this feature can be seen in almost every one of the present mutual funds; they’re the outcome of a competition, innovation, and natural selection, all happening within the surroundings of an efficient market.

Similarly, we also need to take into account apparently illogical human traits, such as overconfidence and fear of losing money, as natural aspects of our own evolutionary wish to stay alive within the surroundings of the economic system. As the Adaptive Market Hypothesis displays to us, all of these things can assist us to comprehend changes in the market.

Chapter 3 – Human beings are certainly irrational when it comes to handling money.

One of the weaknesses of the Efficient Market Hypothesis is – it believes the rational investors will overshadow the effect of irrational investors. Even if all of us accept that humans are very likely to make errors and use poor decisions, the question is still: how negatively can these deeds affect the market?

Firstly, it beneficial to know just how irrational humans tend to be when we talk of taking risks, determining probability and making financial choices.

Psychologists Daniel Kahneman and Amos Tversky have performed insightful research that displays how wrong we can be when we talk of high-risk economic choices. Their result indicates that people have the tendency to more bothered with evading losses than getting gains, which entails that we will usually take greater risks so we can avoid those losses than we will win the jackpot.

This tendency is called loss aversion, and it is an essential idea to remember since it plays an important role in how financially incompetent we can be.

How severe can loss aversion become? Consider, a junior trader named Jérôme Kerviel at the French investment bank Société Générale. In 2008, Kerviel saw himself with €4.9 billion in losses after he attempted to hide some fairly small losses through one irresponsible trading choice after another. The psychological strain of loss aversion made him to continuously “double down” rather than just reducing his losses.

Another irrational tendency is called probability matching, which happens when we’re attempting to forecast what’s going to occur next.

Let’s assume we’re at a roulette wheel, and after seeing the last few spins, we’ve observed that red has been showing more often than black; as a matter of fact, red has been appearing 75% of the time. As a result of probability matching, the majority of the people’s instinct would be to gamble on red 75% of the time.

But, if the trend persisted and the result was really red 75% of the time, and we just gamble on red 75% of the time, our probability of winning would just be 62.5 percent – not really great probabilities after all. The smarter; however less human, the decision would be to stake on red 100% of the time and win 75% of the time.

Chapter 4 – Human action is shaped by our feelings and impulses.

What precisely makes us really susceptible to irresponsible and irrational choices when dealing with money?

Neuroscience proposes that the answer depends on how inextricably connected our choices are to the emotional aspect of our brain.

For instance, sex, gambling, and cocaine all give the same effect in our brain: the production of the neurochemical dopamine, which gives a very rewarding, pleasurable sensation. Through broad research, neurologists have deduced that dopamine plays a vital role in making people take unreasonable risks.

This is something well known to the gambling industry, as slot machines are intended to keep dopamine levels rushing in other for gamblers to continue gambling even as their money vanishes. The machines have the added psychological manipulation of setting up a loss as nearly being a win, which has also been verified to initiate the secretion of dopamine. Therefore, even if a player just gets two out of the three cherries required for a jackpot, they get more delight than they would if the game was a stern win/lose situation.

With adequate repetition, dopamine-related events such as this can simply become habit-forming and cause a damaging addiction.

However, what’s also significant to know is the condition our mind is during emotional states where dopamine is concerned. During these instants, we are very more likely to make choices based on instinct rather than rational thought.

This is a thing pilots have to be continuously taught to know. If the engines of an airplane were to fail and make it fall from the sky, it would be normal for the pilot to fear and automatically pull up on the controls. But, this would really make the plane to decrease its speed even more and hence make a safe landing much less possible. What the pilot needs to do is the angle the plane downward in for it to acquire speed so that it can stabilize for a smooth landing.

Because this is really a counterintuitive reaction, airline pilots experience hundreds of hours of training so they can overwrite their natural instincts.

Unfortunately, when handling money and attempting to make the right choices, we’re usually in a dreadful state of mind and feel the intensified emotional state of panic that comes with it. This, in turn, is how we eventually make unreasonable errors and accumulating preventable losses.

Chapter 5 – The survival of the wealthiest is the vital drive behind the competition, innovation, and adaptation.

You’ve probably heard of the word, “survival of the fittest,” right? It’s an interpretation of Darwin’s theory of natural selection, which asserts that only those with optimal personalities will remain alive within specific species and surroundings, and gradually, we will see these personalities become more prevailing.

As the Adaptive Market Hypothesis demonstrates to us, economies work very much in that manner, and it’s the regulators, investors, insurance companies and hedge funds that are attempting to stay alive.

But, instead of “survival of the fittest,” in the setting of financial markets, we can notice that the law of the land has turned into “the survival of the wealthiest.”

This is maybe best demonstrated by checking how hedge funds have grown over the years.

Hedge funds are alliances between rich investors, and they’re the idea of Alfred Winslow Jones, a statistician, and sociologist. In 1949, with the amount of $100,000, Jones began the first hedge fund as a means to purchase beneficial stocks he anticipated would develop in value while selling short the weaker stocks he assumed were poor. By doing that, he was basically hedging his stakes and decreasing some of the risks inherent in investing –thus, the name hedge fund.

For the following two decades, this first hedge fund was generating yearly earnings of above 20%, and Jones was presented in a Fortune magazine profile. Although the exact approaches utilized by hedge funds are still made secret, they were quickly showing everywhere.

This is the evolutionary nature of the adaptive market working: a new, superior type is introduced and quickly starts to increase and rule.

Obviously, not every hedge funds make the correct choices, and the weak ones can immediately perish. However, the effective ones are usually fiercely successful and, up till now, a lot of new ones arise every year as the market’s process of natural selection proceeds.

Chapter 6 – The Adaptive Market Hypothesis can be utilized to make good financial choices.

As we have seen in the former chapters, when the efficient market is working well, all stock costs correctly reveal their real value. This is called a state of equilibrium.

As stated by the Efficient Market Hypothesis, costs have a tendency to fluctuate from occasionally; however, the market will ultimately go back to equilibrium. And this is the reason long-term investments are reasonable, as they let you see through the fluctuations, safe in the understanding that it’s only a matter of time before your investments reach their actual value.

It seems good in theory; however, there might be an even better idea that develops from the Adaptive Market Hypothesis.

Nevertheless, there are some markets that will experience downturns longer than any investor can sensibly anticipate to wait out. For instance, in the year 1991, the Japanese market crumbled and stayed stagnant for the following 20 years, a period called the “lost decades.”

No investor should be required to wait that long for equilibrium to reach, which is the reason why remaining passive isn’t usually the best thing. However, it’s sometimes good to get accustomed to the changing situations of the market.

Let’s assume that the cost of a stock intensely falls due to a few unreasonable investors who want to sell at every means possible. The efficient market method would be to disregard this downturn, trust that the price will ultimately go back to normal.

But, in some cases such as this, what’s called a behavioral premium may occur. This is when the unreasonable deed becomes the leading general idea and more investors begin pushing to sell, hence badly affecting the long-term value of the company. In this case, depending on an efficient market would be foolish.

The better way to act would be to take a dynamic tactic and be prepared and willing all the time to change your investments in relation to whatever situation may occur. In the above case, this would entail also selling the shares that are dropping in value.

Chapter 7 – Financial crises are due to markets changing without appropriate oversight.

After the 2008 financial crisis, when investors were confronted with the hard choice of how to respond, a lot of them began pointing fingers and finding clarifications. Therefore, what occurred?

The majority of financial crises are an illustration of what occurs when a market evolves faster than investors can adapt.

In most conditions, adaptation occurs over long stretches. For instance, the great white shark has had 400 million years to turn into one of the ocean’s dangerous animals. However, if you remove it from the water and put it on land, it would be unable to adapt to the very different conditions and would die immediately.

A lot of financial establishments are just like that: they’ve used a lot of decades doing things one manner and find it hard to adapt to radical change.

During the 1990s, the financial market experienced a lot of unprecedentedly sudden changes, and at the core of it, all were new adjustable-rate mortgages. In order benefit from these new mortgages, a number of new business choices appeared, such as collateralized debt obligations, which branded the mortgage in an elegant new securities bundle, and credit default swaps, which could be utilized to buy and sell insurance against debt, thus supporting even more investors to become part of the fray.

When these new prospects starting, a housing bubble was made. By 2003, more than $3 trillion worth of mortgage-related securities were distributed in the United States; meanwhile, with a few exemptions, economists remained to be largely unaware of the likely repercussions with these mortgages.

Also, in 2006, housing prices peaked and started to drop while interest rates were increasing. Due to that, a lot of homeowners were forced to default on their mortgage payments, causing a series of events where the value of banks’ investments dropped, making share prices reduce and leading to full-on panic.

When people eventually understood what was going on, it was already really late then; the whole mortgage industry was falling, taking the financial industry with it.

By viewing things in light of the Adaptive Markets Hypothesis, we can get a better knowledge of what occurred. However, could the theory even have stopped the crash from occurring initially?

Chapter 8 – The Adaptive Market Hypothesis can restore more than only our financial system.

If the Adaptive Market Hypothesis can assist us to understand what happened in 2008, can it maybe also show us a better way forward, with more dependable markets?

What the past says to us is that we require better legislation to assist stop greed and fear-based choices from destroying and damaging our economy.

Robust legislation can play a vital role in keeping our financial systems under control. In 1992 after the USAir Flight 405 crashed, the National Transportation Safety Board (NTSB) concluded that the crash didn’t occur as a result of faulty technology or any wrongful action on the part of the crew; instead, it was caused by systemic errors within the aviation industry.

Since it is an independent institute different from the airline industry, the NTSB was able to do an effective inspection and provide its unbiased results, which enabled them blamed the reckless airlines and poor regulations.

If we truly want to avert future financial crises, we require a financial equivalent of the NTSB to inspect and analyze present issues and devise better regulations.

 Eventually, what the industry should attempt is a means to make the world a better place.

There’s no cause why the financial industry should stay the same with greed and selfishness when it could use its influence for the good of all people.

For instance, there’s presently really little private investment being made in the field of biomedicine because it’s seen as a high-risk field in which rewards commonly take ten years or more to attain. However, if we offered this field the type of attention we’ve given others, we could really cure cancer within our lifetime.

For instance, there could be a “CancerCures” fund, led by a panel of biomedical experts and skilled healthcare investors. There could be 150 independent research projects within it sponsored by public investors through the use of bonds, similar to the type that assisted fund the allied war effort during World War II.

These research projects could be structured in a diversified way to minimize risk and provide a high possibility of good returns. With 150 independent projects searching a wide range of treatments, we can predict a 98-% likelihood that at least three of them would be successful.

This would join mass investment with a virtually certain payday! And it doesn’t have to stop at just cancer. With this type of model, there’s no boundary to the likely developments humankind could make.

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo Book Review

We’re long overdue for a new method to our financial markets, one that admits the human errors of those contributing to the system and sees the great potential the system has to do good. This is what the Adaptive Markets Hypothesis tries to offer by combining the evolutionary component of markets.

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