Andrew W. Lo: To Survive Adaptive Markets, Look to Biology
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Do market prices reflect all available information? It depends.
The 2013 Nobel Prize in economic sciences, which recognized the work of Eugene Fama, Robert J. Shiller, and Lars Peter Hansen, acknowledged the efficient market hypothesis (EMH) as a good starting point for understanding asset price behavior, but also suggested that other factors should be considered when trying to make sense of market movements.
Andrew W. Lo, the Charles E. and Susan T. Harris Professor of Finance at the MIT Sloan School of Management, thinks that those other factors can be found outside the discipline of economics.
At the CFA Institute Fixed-Income Management 2018 Conference, Lo explained that the traditional investment framework is not wrong, it’s just incomplete. “Markets behave much more like biological ecosystems rather than physical devices,” he said. “In a stable environment, stable investment policies will emerge — that’s the efficient market hypothesis that we all know and many of us believe in.”
Markets have been much more dynamic in the past few decades, and Lo believes that a dynamic environment is going to yield dynamic investment policies. “I think that biologists should be telling us economists, ‘You know, it’s not the economy, it’s the environment,’” he said. “And environment is what shapes behavior.”
According to Lo, “We are constantly observing our environment, looking at the risks, and optimizing our Sharpe ratio across all of the different aspects of human behavior. Risk/reward tradeoffs happen all the time, and we don’t always process it in the most accurate way.”
As an example, Lo cited Sam Peltzman, an economics professor who found that increased automobile safety regulation was not clearly linked to fewer traffic fatalities. Peltzman theorized that drivers were adapting to their safer vehicles by taking more risks — although some of the risks had been shifted, resulting in fewer driver injuries but more to pedestrians and other motorists.
This “Peltzman effect” was confirmed when researchers found that increased safety regulation in NASCAR racing led to more on-track accidents and an increased risk to both spectators and pit crew members.
In financial markets, these unintended consequences can be devastating. Lo said, “Human nature draws us, like a moth to a flame, to high-Sharpe-ratio assets.” And he noted that our perception doesn’t always correspond with reality. The commonly accepted risk/reward tradeoffs observed in different asset classes may apply over long periods, but Lo warned that they don’t apply over every period.
“If we believe that there’s a risk/reward tradeoff,” Lo said, “presumably the periods where we’ve got high volatility, we’re going to have high return, and periods where we have low volatility, we should have low return.” Then he pointed to times in the 1930s, 1950s, and 1970s that combined high volatility with low average returns and thus challenge that belief.
By recognizing these tendencies, investors can adapt to the adaptations of others. This can help them survive in dynamic markets roiled by high volatility and uncertain price movements. The first step is to identify the difference between active risk management and active investment.
Lo has a problem with the status quo: “If you want risk management nowadays,” he said, “you’ve got to go and start using active investment strategies.”
But that doesn’t have to be the case, and Lo believes it’s possible to engage in active risk management without getting involved in active portfolio management. “We need to break that link,” he said, asserting that modern technology allows investors to construct a portfolio that engages in active risk management while remaining skeptical about the existence of alpha.
Ultimately, Lo’s message for investment professionals was an optimistic one: “If you think about the full spectrum of all the different characteristics that span the various different financial products that you manage — things like risk control, liquidity, credit, turnover, currency exposure, Sharpe ratio, maximum drawdown — there is a host of investment opportunities that are currently untapped.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey