Adaptive Markets: Financial Evolution at the Speed of Thought

by Andrew W. Lo

A new, evolutionary explanation of markets and investor behavior

Half of all Americans have money in the stock market, yet economists can't agree on whether investors and markets are rational and efficient, as modern financial theory assumes, or irrational and inefficient, as behavioral economists believe--and as financial bubbles, crashes, and crises suggest. This is one of the biggest debates in economics and the value or futility of investment management and financial regulation hang on the outcome. In this groundbreaking book, Andrew Lo cuts through this debate with a new framework, the Adaptive Markets Hypothesis, in which rationality and irrationality coexist.

Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, Adaptive Markets shows that the theory of market efficiency isn't wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit. Lo's new paradigm explains how financial evolution shapes behavior and markets at the speed of thought--a fact revealed by swings between stability and crisis, profit and loss, and innovation and regulation.

A fascinating intellectual journey filled with compelling stories, Adaptive Markets starts with the origins of market efficiency and its failures, turns to the foundations of investor behavior, and concludes with practical implications--including how hedge funds have become the Galapagos Islands of finance, what really happened in the 2008 meltdown, and how we might avoid future crises.

An ambitious new answer to fundamental questions in economics, Adaptive Markets is essential reading for anyone who wants to know how markets really work.

Genres: Economics, Finance, Business, Nonfiction, Psychology, History, Audiobook

483 pages, Hardcover

First published May 2, 2017

About the author

Andrew Wen-Chuan Lo is the Charles E. and Susan T. Harris Professor of Finance at the MIT Sloan School of Management. Lo is the author of many academic articles in finance and financial economics

Reviews

[Athan Tolis · Rating 4 out of 5]

Andrew Lo specializes in derivatives. What he does not know about them is really not worth knowing. Funny thing is, there isn’t one sentence in this book about derivatives. A very highly-regarded author and academic has written a book about the physiology of fear, the experiments of Danny Kahneman, the chemistry of pleasure, Charles Darwin, quantum mechanics, but not his subject of expertise.

How come?

Once upon a time, many good (and other not-so-good) people believed that the role of derivatives was to “complete the market.” So, for example, if you “short” the stock of a company via a put option, by construction a feature is built into that put option that in the market is called a “stop-loss:” You cannot possibly lose more than the “premium” you paid to buy the put. A guy who borrowed the stock and sold it on margin can in theory lose an infinite amount of money if the trade goes against him. You can’t.

Such a “stop loss” does not grow on trees. It does not exist in nature. So this is a way in which a put option “completes” the market for trading in the stock of this company. You can now gain negative exposure to the stock of this company in a manner that was previously not available. If the market in the stock of this company gaps up (for example, doubles) without trading the prices in between at which it would have been necessary to buy the stock back to enforce a “stop-loss,” that is somebody else’s problem. Not yours.

That is but one example of many where derivatives “complete markets.”

People like Andrew Lo spend their time as academics examining, understanding and explaining to others how these constructs work.

Sadly, while derivatives do indeed complete markets, that’s not at all how we use them. Derivatives, 99.9% of the time are entered into by end-users for much more prosaic reasons. A poor guy who cannot borrow money can use them to obtain otherwise unobtainable leverage. A fund manager in Orange County who fancies himself the next George Soros can use them to circumvent his mandate. A country like Greece can use them to legally move its debt “off balance sheet” to meet the Maastricht criteria. An investment bank like Goldman Sachs can buy them from other counterparties of AIG to hedge against the potential demise of… AIG. (Sorted!) And so forth.

Which leaves academics that study derivatives in a funny place. They teach PhD’s about derivatives and then these guys, clutching their diplomas, mostly go to work in “risk,” a function within a financial institution whose chief role is to devise excuses for why whatever trade the boss wants to do fits within his mandate. Or alternatively, they function as the “fall guys” if something goes wrong, because their job description was to rubber-stamp whatever strategies or procedures went wrong.

This does not mean financial economists know nothing. They know a whole lot. And they come in contact with loads of movers and shakers. And at least they understand deeply, at the formula level, the mechanics of the instruments that are causing many of our problems in finance today. It’s just that finance theory, per se, is at right angles to the solution of our problems, precisely because financial innovation it is not used in the way that is predicted by finance theory.

To put it differently, if I use a thousand dollar fountain pen to stir my coffee, the senior engineer at Montblanc may not be a guy with knowledge relevant to my life. If everybody uses his thousand dollar fountain pen only to stir his coffee, the senior engineer at Montblanc is entirely surplus to requirements. Except, of course, if he’s friends with all the guys who buy his pens, knows their stories and can tell you how they all go about stirring their coffee (assuming you care to know).

And that’s what we’ve got here:

Hot on the heels of Richard Bookstaber’s “The End of Theory,” (whose previous book, incidentally, he trashes by implying its “high complexity” and “tight coupling” theory is cribbed from a 1984 book by an author called Charles Perrow), Andrew Lo has written a book that not only

1. explains that there is no such thing as a “homo economicus” who always correctly and rationally computes the best course of action for his economic life, but also

2. proposes an alternative way to explain the world

The fundamental insight is that economic agents (you and I) are driven by behavior that is pre-programmed into us by evolution. Andrew Lo’s conclusion is that this behavior must by nature be adaptive, because that is the type of behavior that evolution rewards. That is the “Adaptive Markets Hypothsis.”

The author does not get there fast. What we have here is a tremendously entertaining, witty, often wordy, but never boring tour of the natural sciences and how the author thinks they pertain to man’s attitude to risk and uncertainty.

Does it add up?

For me, it doesn’t.

I’ve spent 25 years trading, for a good 8 or 9 institutions and I promise you that if anybody thinks past year-end he will trade in a manner that will get him fired. Hell, you probably should not think past month-end if it’s a career in finance you want. How on earth that individual behavior somehow conspires to add up to collective behavior that becomes adaptive, and how anybody can think that when all we observe around us is stuff like Bitcoin trading at 2000 is beyond me.

I guess Andrew Lo is saying we should behave adaptively. But the observation that when things are calm homo economicus is a good model and when all the little pockets of value have been arbed all bets are off is resolutely not the same as saying the adaptive model is the one that should guide a market observer in the small. Rather, you need to do what Chuck Prince said and dance when the music is playing. I would contend that Warren Buffet is doing no different, but has the deep pockets and corporate structure to not get killed when the dance floor gets slippery…

And yet, for me “Adaptive Markets” was pure entertainment. If the book was 800 pages rather than 400 I would have read it anyway, because I had a super time reading it. There are tons of fun things here that have nothing to do with markets, but were a joy to read and think about. Like, I finally found out what “New Math” was and I’ll order the books for my kids. Or there is a treatise on what it means to be intelligent (Andrew Lo’s answer: the ability to put together good narratives) Stuff like that, which I totally loved.

There’s also some annoying stuff for geeks like me. For instance, despite explaining toward the end of the book exactly how positive feedback can get a microphone to squeal, the author does a solid impression of an HR lady at the beginning of the book when he keeps discussing “positive feedback” and “negative feedback” in the context of how people answer surveys. Sloppy.

So that’s really it. A hyper-wordy book, a whirlwind tour of all departments at MIT, I guess, from sociology to psychology to neurobiology, with stops to take pictures of the 2007 quant meltdown and the 2010 flash crash, best exemplified by the rather facile explanation of prospect theory (it’s because of the amygdala, who is not a character in Star Wars, read the book to get the scoop), but a tremendous read if you are a nerdy guy like I am.

If, unlike me, you are not a dweeb, you should probably skip, though.

[Mbogo J · Rating 5 out of 5]

As I was slogging through a lot of brain terms which I had little interest in memorizing (it seems Lo is a fan of neuroscience) I kept asking myself, I am halfway into the book and I still do not have a full grasp of what adaptive markets is all about. Without a primer from Andrew there was no way of knowing whether a course of action is due to adaptive markets or if it was efficient markets.

My eureka moment came about three quarter way into the book when I related Andrew's ideas to an idea I had come across when reading Bookstaber's The End of Theory. In that book he had put forward the idea of agent based modelling, rather than using the idea of a blanket rational economic man (Andrew calls him homo economicus) Bookstaber proposed we model individual agent behavior and how it relates to other actual agents. What Andrew did was develop a full theory out of that idea and many others.

Andrew posits that markets adapt to their ever changing environment and whatever was profitable yesterday is incorporated into today's market and is no longer profitable. To make profits money has to chase ever more esoteric sources of returns and this race is a greased decline into bubbles and crises. To prevent this certain doom Lo proposes a raft of measures many of which center on the idea of dynamic scoring or metrics. He also calls for an increased incorporation of the human into the equation among many, many good ideas.

As it is, this book and its attendant theory is more of a policy recommendation rather than a new way of portfolio allocation. The profit motive is suppressed and Lo is more concerned about the financial system's sustainability rather than making millionaires overnight. His ideas are merited but this lack of profit motive robs them of the airspeed they need to get airborne and into the public domain, which will be a shame. I hope over time his ideas gain traction and join the zeitgeist. A minority thesis is his use of the ecosystem to describe the financial system. I found the analogy to be apt and thought to myself we gave finance to physicists with their fancy models and look what that did to us? It is time we give finance to ecologists and see what they will whip up. The future is biological.

[Chris Esposo · Rating 2 out of 5]

A disjointed tour of mostly non-utility based approaches to predicting financial markets, taken mostly from a neuroscience/"behaviourist" perspective at the micro level and at a quick tour of simulations, agent-based perspective at the macro level. The fly-by of these two broad perspectives are capped at the beginning with a review of the rational expectations approach of Samuelson/Sharpe/Fama of economics and finance and a very very short discussion of how one can use finance to fund innovation in medicine and science at the end.

I was surprised at two things about this book, one it's claimed to contain exciting new ideas, which it does not. I'd argue the kind of things that Lo is discussing, especially the approach he's advocating for, to build a formalism where market participants are mostly reactive to their environment, has been around since the 80s, and he really doesn't do enough justice to the people who pioneered this approach and continue to utilize it with little fanfare at SFI. The second thing that shocked me about this book is that for a text with a blurb on the cover claiming reading the book will "make you rich", there is little of practical value in the book. It is mostly an incomplete academic history of types of heterodox economic models and theories, and not much more.

What it does do, including citing the obscure history of the adaptive market thesis from two professors at what became CMU Tepper, explain why neuroscience really destroys traditional utility-based theories, and outline how some people have exploited what traditional economist would call "inefficiencies" in a lot of small ponds to make money, it does fairly well.

Some small notes, if one is interested in the exposition at the beginning of this book about the history of rational expectations, and want to hear more from a critical eye, there's a much better treatment of that subject title, "The Myth of the Rational Market", and it covers much of what Lo mentions and more, but mostly from the view of how impacted academic economist, not financial academics. Though the difference between the two isn't all that large for a layman. Also, there's some incompleteness in Lo's treatment of evolution and selection. In one set of paragraphs, Lo criticizes how social Darwinism naively deployed the notion of selection to justify malicious policies. Agreed, yet he never makes a real strong case on why I could naively deploy "selection" to the financial markets and that synthesis be a cohesive paradigm that reflects reality. He only states that financial ideas can be selected and evolve much faster cause don't have to go through a reproduction cycle to propagate. At best his exposition is a weak feasibility argument. These ideas too have been treated much better by non-economist in data science studying memes.

In summary, not really sure who this book is for, maybe a general reader interested in the history of ideas? People seeking books to help learn stock trading or analysis get little here they couldn't get elsewhere - much too theoretical/academic, and for any serious person doing this stuff already, there's literally nothing new here that you couldn't get from papers published in the last 20 to 30 years outside of mainstream economics. Lo should have written more original content. The bit about his mother died from cancer, and his desire to help solve cancer and other diseases with his knowledge of risk management and finance was touching, it should have been emphasized at the beginning, and served as a thematic motif, as is, it was bolted on at the end, and the whole subject of using finance in this way got too little exposure in the book. In its current state, not recommended

[Otto Lehto · Rating 3 out of 5]

What do financial markets have to do with Darwin or the neuropsychology of decision-making? A lot, it turns out. Lo's book gives some suggestive reasons to think in evolutionary terms, even if it falls short of providing a coherent alternative paradigm to the established models of financial economics.

The many failures of contemporary economic models have led to a string of attempts to refine them. The more rambunctious iconoclasts have sought to get rid of the main tenets of neoclassical economics - expected utility theory, the efficient market hypothesis, and "Homo economicus" models - and to replace them with alternative hypotheses that are allegedly more realistic and practically sustainable. In recent decades, some of the most fruitful attempts to refine neoclassical economics have come from adjacent sciences, especially psychology and biology. Lo's "adaptive market hypothesis" belongs to this camp, and it should be seen as a synthetic application of those insights (specifically of behavioural psychology and evolutionary/population biology).

But the book doesn't really know what it wants to say - or how it wants to say it. The adaptive market hypothesis, in some of Lo's boldest moments, is presented as a general new theory of economics to rival and replace the efficient market hypothesis and the behavioural model of Homo economicus. This would mean the rewriting of all economics books. But it doesn't quite have the specificity of formulation, nor the generality of application, to match those insights. Instead, it is something more modest but still worthwhile: an alternative framework or lens through which to analyse certain macro and microeconomic trends, especially in the field of finance.

So, the book suffers from an identity crisis and a lack of focus. This is related to the other problem with the book: its needless length. It doesn't have enough unique things to say to justify its scope. It is rather well written, but many of the sections are only tangentially related to the main topic of the book. They cover well-known territory, such as the experiments of Kahneman and Tversky. These sections are well-written but they do not say anything that is new or interesting. The best parts of the book, unsurprisingly, are those that deal with hedge funds, derivatives, and financial crises. Financial markets are what Lo is an expert on, but the book spends too little time with them. So, it would have been a better book at 1/2 or 2/3 of the length, with a tighter focus on financial markets, and with a more rigorous discussion of the idea of adaptive markets as applied to them.

Overall, I do not regret my time with the book, but it slightly disappoints with its lack of overall focus, its lofty claims that fail to deliver, and its excessive length. Also, it doesn't have the originality to be the most recommended popularizer of behavioural psychology. And, by going to those well-trodden places, it manages to stray from the core message of the book. However, as a contribution to the analysis of how evolutionary ideas from biology can be applied to finance, it constitutes an interesting although somewhat scattershot contribution to evolutionary economics.

[Premal Vora · Rating 3 out of 5]

Andy Lo is a nice guy. Nice people have good intentions. Some wise person once said, "The road to hell is paved with good intentions."

The good:
So many behavioral biases that demonstrate that people don't necessarily behave in a way that is consistent with decision-making axioms have been documented in the scientific literature that there is now a well-accepted field in economics and finance called "Behavioral Economics and Finance." The question is why do people behave this way? The answer may lie in a million years of evolution and how the human brain has evolved.

Lo provides a very basic introduction to the concept of "market efficiency" which is well known to any financial economist, but has barely permeated the world of individual investors. But then, he goes on to discuss some of the evidence against market efficiency. But, most importantly, he does a very nice survey of how neuroscientists are collaborating with economics and finance scholars to better understand the biological drivers of behavioral finance and how that might affect market efficiency.

Lo then postulates a replacement for the Efficient Markets Hypothesis called the Adaptive Markets Hypothesis that relies on some of his research in finance and some of the literature that studies the connection between neurological processes and decision making.

The bad:
Any new theory that is postulated to replace the received wisdom must have testable implications (according to Karl Popper). It's not clear what the testable implications of the Adaptive Markets Hypothesis are. Maybe it'll take us a while to agree on what they are. But, a casual reading of the hypothesis suggests that it fits the data too conveniently .

Lo also cites way too many of his own papers. It's true that he's a well respected financial economist. However, it frequently comes across that he's comparing himself to the likes of Kahneman and Tversky. Well, Andy, you have a long ways to go before you're in that league. If you read Kahneman and Tversky's work, they consistently demonstrate personal humility and respect for their colleagues' work. It would serve you well to learn from them.

The ugly:
One of the goals of this work is to understand the 2007-2008 financial crisis and provide some suggestions for avoiding the "meltdown" that occurred at that time. At one stage, Lo suggests that any employee who earns above a certain amount in a firm should be held personally liable for the risky bets made within that firm. Really?! Have you thought about this suggestion carefully Andy?

The bottom line:
Read this book for a simple explanation of market efficiency and some of the evidence against it. Also, read this book to get a nice introduction to the new literature that connects neuroscience to economics and finance. The rest of the book should be read with a healthy dose of skepticism.

[Mehrsa · Rating 4 out of 5]

This book was not an easy read, but it is worthwhile. The thesis is both necessary and obvious. Of course, markets evolve and adapt, but as the author says, sometimes you need a new theory to shake an old one (the old theory here is the efficient markets hypothesis). There is a lot of unnecessary background materials on evolutionary science and other market theories, but the payoff at the end is worthwhile.

[Armen Grigoryan]

This is an effort by Lo to bring evolutionary biology to economics and help the discipline to enrich and have more understanding of human nature and the environment created by humanity. If Darwin was alive this would his favorite book on economics.

[Benji · Rating 5 out of 5]

We shouldn't let finance drive our goals; our goals should be driving finance. The finance of the future will be able to address all of our social priorities. Consider a world where many megafunds are hard at work, not only at the difficult task of curing cancer, but wherever there's an important social goal with a possible technological solution, whether it's curing rare and orphan diseases, developing new source of energy, moderating the effects of climate change, or finding new treatments for heart disease, diabetes, Alzheimer's disease and dementia. The money is there, and it's possible to structure the research to make an attractive return.
Our human intelligence will harness our collective fear and greed to solve our global problems. We can improve a market, a method, or an entire financial system, adapting it to our needs and the challenges of our environment. The same traits that make the financial system prone to the madness of mobs also make the financial system extremely effective in gathering and deploying the wisdom of crowds. Finance doesn't have to be a zero-sum game if we don't let it. We can do well by doing good, and if we all work together, we can do it now.

[Diego · Rating 4 out of 5]

This one took longer than it should have and I’m pretty sure it was due to it not being entirely what I thought it would. Half of it was spent talking about evolution to set the stage for his mindset regarding market activity. A few more chapters were about the 2008 crash as well, which is well covered. I guess I got a little disinterested during the book.
I agree with another review here that this is just a start for another theory of market activity. The jist of the theory is that humans make market actions based on our evolutionary existence. We are fearful and greedy, our very primal instincts are what drive the market. I agree that no basic stable economic “model” can predict the market, but I’m not totally sold on his analysis....yet. Though, not many economists are sold on prediction by psychology. This is still new territory. Though more definitive studies and data are needed, not just realizations and making connections based on empirical evidence. But logically it makes sense. Humans are very primal, especially in a capitalistic environment.

[3thn · Rating 4 out of 5]

I love how Andrew takes you on a journey of evolution and intertwine views the financial system with an evolutionary perspective. He shows the limitations of the Efficient Markets hypothesis, where it fails, and proposes that there has to be new way of viewing markets. Of course, he gives his own take on the financial crisis and other events through his own lens and why the system failed, beyond the usual narrative. He ends on a optimistic note of a financial utopia where people's investments end up in hedge funds that do good. I wished he talked about the rise of blockchains to see how it could / could not fit into this view of the world. He completely neglected it. Great and entertaining read in general

[Michael Huang]

This book is supposedly discussing an alternative to the efficient market hypothesis (or EMH). The EMH says the market as a whole knows very accurately what the value of each security is and the trading prices is thus correct. The corollary is that as an individual investor, you won’t be able to find an underpriced security to buy. In reality EMH is approximately true, especially with regard to the corollary, hence the advice of buying an index fund. But there are many cases EMH fails, and there are significant cases of mispricing. What do we do?

The alternative proposed in this book is called adaptive market hypothesis (AMH). It lists known sources of problem for EMH: human are irrational and can make many decisions while being irrational. So what is AMH? It’s a tautological hypothesis that essentially says the prices reflect information as well as market participant’s behavior. This is not a hypothesis with predictive power. (I have a better hypothesis: price of a security is what the buyer paid the seller in the most recent transaction and is a function of what the buyer and seller’s general condition, including what they ate for breakfast.) You can test EMH with all sorts of experiments. For instance, a group of stock pickers as a whole can’t beat the market. Those experiments show time and again EMH is not accurate but perhaps good enough for the non-professional. But AMH offers no such falsification opportunity. There are only vague examples: when everybody is selling in a panic, EMH dictates do nothing and wait for price to recover. AMH says sell. Note that AMH doesn’t say sell when the price drops, but only when everybody is in a panic. Trouble is: how do we know everybody is in a panic? In many cases buying when prices have fallen a lot is an easier to follow algorithm and remarkably consistent. Exhibit 1: Warren Buffet.

So microscopically, AMH does not appear to be (a) clear enough to tell us what to do and when exactly to do it, or (b) possessing logic or empirical evidences that support the general vague principle (of selling when everybody is in panic). How about microscopically?

Here AMH seems to be on a surer footing. Because of irrationality, market will be repeatedly in crises which not only disrupt the financial sector, but impacts the rest of the economy. Independent regulation (perhaps following the model of NTSB) would be useful. (Policy setting is far from my field, so I can only say, it sounds fine to me.)

[Daniel · Rating 5 out of 5]

This is easily the most important book about finance this decade.

The conventional economic wisdom is the Efficient Market Hypothesis. That is, demand will magically meet supply somehow, and we are all homo economicus. Lo clearly explained why that is not the case, and in the best case scenario this is an ongoing process until the 2 meet in ‘economic nirvana’. Other times, they may never meet and there is ‘economic purgatory’.

Ok so classical EMH is dead, otherwise there will be no hedge funds. Then came the next generation of behavioural pathologists like Kahneman who can point out the hundreds of biases and irrationality that we have. However, criticisms such as these cannot replace the EMH.

So Lo came up with the Adaptive Market Hypothesis. Essentially the environment changes behaviour and ensure survival of the fittest given that environment. When the environment changes, species that are too optimised in the old environment die like the dinosaurs, and the more flexible and humble species (like mammals) survive. This explains why a successful hedge fund strategy will be copied, making it progressively less profitable except by increasing leverage. This then creates systemic risk because they all use the same strategy: when the environment changes, all the funds fail at the same time.

To mitigate that risk, Lo proposed: 1. Changing the environment to reward performance but punish taking too much risk, especially for finance companies. He suggested that regulators asking for anonymised real time report to assess total risk, to control risk in a timely manner. 2. Monitor traders and come up with algorithms that can predict extraordinary risk, with a Chief Risk Officer who reports to the board directly and who cannot be fired by the CEO.

The last chapter showed his optimism for financial instruments such as bonds to defeat cancer and poverty.

Wow. I think Lo’s theory makes the most sense out of all the economic theories, while also taking into account our biases. However the risk mitigation part is going to be very difficult, if not impossible to be carried out, since we had not really done much after the 2008 crisis and now we ha e forgotten all about it. But this is a start.

[Logan · Rating 5 out of 5]

Professor Lo has written the finance book I wish I could have written.

The book’s title is central to the story, but not the story entirely.

Adaptive Markets is split into thirds:

First, a history of not only the study of finance, but also neuroscience, biology, and evolutionary theory, explaining how the latter inform the former.

Second, these disparate fields of study culminate in Lo’s “Adaptive Markets” hypothesis, which is summarized by these five principles (verbatim from page 188 of the hardcover):

“1. We are neither always rational nor irrational, but we are biological entities whose features and behaviors are shaped by the forces of evolution.

2. We display behavior biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback.

3. We have the capacity for abstract thinking, specifically forward-looking what-if analysis; predictions about the future based on past experience; and preparation for changes in our environment. This is evolution at the speed of thought, which is different from but related to biological evolution.

4. Financial market dynamics are driven by our interactions as we behave, learn, and adapt to each other, and to the social, cultural, political, economic, and natural environments in which we live.

5. Survival is the ultimate force driving competition, innovation, and adaptation.”

The final third concludes with Lo’s analysis of the current state of the financial industry and how to improve it. Regulatory examples, such as the National Transportation Safety Board (NTSB) model, provide routes for root cause analysis without finger-pointing. The concluding chapter on financial innovation for good is the material every wannabe-investment banker should read before beginning his or her career. There is so much great intellectual content in Adaptive Markets that it’ll be one of the very few books I reread.

[Mikko Savolainen · Rating 5 out of 5]

A wittily written look at contemporary finance, the book blends behavioral and financial economics, psychology, neuroscience, biology and ethics to paint a big picture of the nature of financial markets. If I had to summarize the book, I'd call it a highly entertaining and inspiring introductory tome for anyone looking to understand financial markets from a humanistic point of view.

That being said, the book does suffer from wordiness. Like the financial markets Lo describes, the book can also sometimes seem very 'organic', ie not very structured. If you find yourself thinking "how is this anecdote even related to what I just read?", take a look at the TOC and try and remind yourself of the topic of the chapter. Or just keep reading and enjoy the ride. What the book lacks in structure and compactness it makes up for in entertainment value.

[Maya · Rating 5 out of 5]

Cool theory. Fun behavioral journey to get there. Lets hope academia allows this idea to continue to evolve ...

[Tadas Talaikis · Rating 3 out of 5]

2.5, pretty vague

[Steven Stringer · Rating 2 out of 5]

I feel like this entire book could have been a long blog post, but instead the author felt the need to flex on me for 483 pages about how smart he is.

[Martin Egeli · Rating 4 out of 5]

A professor saying the Efficient Market Hypothesis does not work is always welcoming. The Adaptive Markets shows how human evolution affects our financial decision making, including many examples from brain research, behavioral economics and more.
I have seen most examples before, and also not really convinced for the the ideas on the "New market".

[Robert Cawley · Rating 4 out of 5]

Andrew is great at interweaving his personal experiences with sound judgments, while creating easily understandable stories to explain complex thinking.

[Fernando Iberico · Rating 4 out of 5]

Desafiar el conocimiento convencional reinante en una disciplina es un requisito forzoso para que la ciencia progrese. Lo inteligente no es desacreditar a las personas detrás de una nueva corriente o idea, sino escuchar, preguntar y examinar los pilares que la soportan.

Por eso, el libro Adaptive Markets: Financial Evolution at the Speed of Though de Andrew Lo cumple su propósito al dar una crítica constructiva a la teoría de mercados eficientes; paradigma central de las finanzas que explica el comportamiento de los mercados (precios incorporan la información disponible) y agentes económicos (racionalidad completa sin sesgos conductuales).

Basándose en profundos conocimientos de psicología, biología evolutiva, neurociencia e inteligencia artificial, el autor argumenta que la teoría de los mercados eficientes no es errónea, sino incompleta. Para ello, propone un nuevo marco conceptual: la hipótesis de los mercados adaptativos, en la que la racionalidad e irracionalidad de los agentes económicos pueden convivir. Asimismo, resalta el impacto del entorno y las relaciones (cambiantes) entre los participantes, cuya interacción puede configurar el resultado (equilibrio) que observamos. Dicha hipótesis ha sido trabajada durante toda su carrera académica y profesional, retroalimentándose con la crisis financiera del 2008-2009 y la contribución de otras disciplinas ajenas a la economía-finanzas.

Si bien es una lectura densa y por momentos dispersa, uno debe poner en perspectiva el aprendizaje que obtiene. Más aún si este proceso viene acompañado por el análisis de un profesional de primer nivel (sin ninguna ecuación o cálculo matemático complejo).

Dada la amplitud de las implicancias de su propuesta, el texto brinda diversos casos relacionados con las finanzas. Desde el mercado de acciones y renta fija; los derivados financieros; el rol de los incentivos en los agentes; la medición y gestión del riesgo; la evolución de las instituciones financieras hasta las políticas de regulación. No obstante, creo que lo más interesante es cómo conecta estos puntos con otros ejemplos (fuera del ámbito financiero).

Con mucho énfasis en el detalle, el autor desarrolla las herramientas que sirven como analogías para explicar su punto de vista. Ejemplos: la evolución en el precio de las acciones de los proveedores de la NASA tras el accidente del Challenger; las islas Galápagos y el desarrollo de los ecosistemas; los avances de la ciencia médica en el entendimiento del cerebro humano y cómo estos se reflejan en los sesgos de comportamiento; la innovación tecnológica y su repercusión en el entorno en el que se desenvuelven las personas, así como su efecto en las decisiones óptimas; los intentos fallidos de los directivos del NASCAR (carrera de autos) por reducir los accidentes fatales de los pilotos enfocándose sólo en las mejoras de seguridad.

[Stephen Hero · Rating 3 out of 5]

Been dishing out too many 4’s and 5’s so I had to think of a book I’ve read recently that was only ok. Repetitive but fun and ultimately worth reading for anyone econ adjacent.

[Bernard Tan · Rating 5 out of 5]

Andrew Lo, an MIT Professor, makes the case against the Efficient Market Hypothesis in this 400+ page book. He brings the reader on a journey over the last 60 years of economic thought and financial development, and in the process introduces the giants of academia, the landmark studies, and the industry practitioners that shaped what is generally believed in the world of finance today. He does this in a story telling way, with he as a character, and with many anecdotes. This makes the entire read pleasant and accessible.

Lo uses biology as his key arguments. He argues that behavioural science clearly shows that homo economicus is fiction. Evolutionary forces have imbued in humans a tendency to deviate from hard cold reason and logic - he shows this in many experiments - because this trait has allowed us as a species to survive under a much broader pool of circumstances. He goes quite deeply into the developments on neural science, but ends with the story of the Tribbles (must read to learn what is a Tribble).

Second, as in nature, markets are not static. The changing external environment of finance - driven by technology, rule changes and participants - always presents opportunities, usually fleeting. And that is what all the funds look to exploit. Competition helps "new species" of funds to emerge, and "old" ones to die, like in natural selection. And this will continue.

The problem however is that we are now evolving "at the speed of thought". This rapid evolution of the markets in search for alpha, without oversight, has made the entire financial system much riskier, due to the "complexity and tight coupling". His book gives you a perspectice of what this is. This is a problem that has to be addressed.

He ends with a message of hope. The power of finance, like in all human ventures, can be harnessed to do good. The system is mature now to allow for the diversification of risks to fund important things like a cure for cancer, the eradication of poverty and the fight against climate change, things not possible before.

I enjoyed "Adaptive Markets" so much, I ordered a hardcover to take a permanent space on my bookshelf. One of the best books I have read in a long while.

[Andrew · Rating 3 out of 5]

Lo is an exquisitely accomplished financial econometrician who, unfortunately, has decided to write a "pop science" book. A "pop science" book is the sort of book that, in my opinion, debases the author's (oftentimes truly innovative) works by regurgitating a lowest-common denominator summary so that a Smart Person can enjoy reading about a Big Idea. In this respect, this book seemed clearly written with the intent of appealing to the kind of person who enjoyed getting Big Ideas pureed and spoon-fed to them from books such as Kahneman's "Thinking, Fast and Slow", "Black Swan" by Taleb, anything by Yuval Harari or Malcolm Gladwell, etc.

The problem with a lot of these books, Lo's included, is that they take a single framework (evolutionary biology), apply it to a completely different domain, and universalize it. And the "evolutionary biology" thing has been getting old. Sam Harris, Harari, Dawkins have beaten this poor, dead horse beyond all recognition. Lo writes in the book that economics suffers from "physics envy", and has lost its way trying to emulate the deterministic world of physics. Perhaps it could be said now that pop science suffers from "evolutionary biology" envy.

That being said, in Lo's defense, the framework is actually quite compelling (at least for the two chapters where he actually talks about financial statistics, instead of regurgitating all of the factoids from all of the pop psychology, pop economics, and pop finance books from the last decade). I think it's a genuinely refreshing and creative interpretation of what modern financial economists call time-varying risk premia. Lo's accomplishment in this book was reframing what has been, since Markowitz invented mean-variance optimization, a stiflingly abstract, mathematical discipline into more practical, sociological terms. Further, Lo does a good job bringing mathematical horsepower to the discussion without overwhelming the reader, referencing a number of papers he published on measuring systemic risk and summarizing their findings.

[Brian · Rating 3 out of 5]

I liked this book, but found it a bit meandering. Lo's core idea (and the title of the book) is that neither market efficiency nor bounded rationality theory fully explain market behavior. Instead, markets are "adaptive," undergoing phase shifts as new technologies create temporary information asymmetries which yield advantage over the short run until the overall market adapts, becoming more efficient (within the limits of bounded rationality). Makes sense, Lo's data seems to back it up.

The rest of the book consists of a variety of personal anecdotes, quick tours through behavioral economics, the Stanford prison experiment, thermodynamics, information theory, the larger social purpose of finance.... All interesting stuff, but seems a little scattered.

[João Veloso · Rating 4 out of 5]

This book is more of a constructive argument for the need of new perspective in finance, investing and how markets work in general than about how markets work.
It shines some light on each bit of the financial institutions, however it is too sparse in my opinion.
Overall it's a good read, but different from what I expected

[Ian Robertson · Rating 5 out of 5]

Andre Lo, professor of finance and director of the Laboratory for Financial Engineering at MIT, has spent his career measuring, analyzing and theorizing about financial assets (stocks, derivatives, funds) and financial markets. Among his many publications is a 2005 paper entitled “The Adaptive Markets Hypothesis”, which sought to integrate traditional and behavioral finance. More than a decade later, Lo has expanded his academic effort into an excellent book aimed broadly at enquiring minds. Well written and with clear explanations of many complex financial theories (traditional and behavioral), the book is a thought-provoking look into the future. Two chapters (1 and 6), in particular are worth the price of admission alone: Lo’s summary of the efficient market hypothesis (EMH) and its relationship to behavioral finance; and his demonstration of biological economics and population robustness as the root of our financial behavioral biases.

As an accomplished researcher himself, Lo cites much of his earlier work. For example, his 2009 empirical work on stop-loss selling would have produced since 1929 almost 1% of alpha (outperformance) annually, and with less volatility over a buy and hold strategy. Lo goes on to highlight other dynamic index possibilities (the best known of which are the target date maturity ones that rebalance every five years or so to match an investor’s age and time horizon).

Lo’s theory isn’t so much a replacement for EMH, but rather a complement to it. It sits overtop and tries to explain the areas in which EMH and modern portfolio theory are deficient – the behavioral aspects of finance. Suggesting a growing need for his theory, Lo states “the relevant question isn’t whether [EMH] assumptions are literally true—few economic assumptions are—but rather, whether the approximation errors associated with them are small enough to ignore for practical purposes. The emerging narrative from the perspective of the Adaptive Markets Hypothesis is that these errors used to be small, but have grown considerably in recent years.”

Despite the historical empiricism though, Lo minimizes the difficulty of identifying in advance what is mispriced and can be exploited. He notes other market imperfections, and offers ways they too might be exploited … for a while, acknowledging they would likely become quickly incorporated into standard financial practice and drop to market performance. In many respects, Lo’s Adaptive Markets Hypothesis is no different than traditional fundamental stock analysis – a tough, never ending quest for cost-effective ways to identify mispriced securities and markets. At least when it was current, Fama and French’s three factor model included identifiable targets (smaller companies and value stocks).

From a more macro perspective, Lo’s new theory also challenges the work of Hyman Minsky. For example, in applying his behavioral hypothesis to the regulation of financial institutions, Lo implicitly aims for smoother markets (and who doesn’t want to prevent future crashes), but as Minsky explains in Stabilizing an Unstable Economy, the very act of stabilization eventually causes crashes: stability breeds instability. Lo assumes that experts will not only be able to identify bubbles or behavioral trends but will be able to profit from that identification. (Even the consummate insider, Alan Greenspan’s comment about the market’s ‘irrational exuberance’ was three years early in 1996!).

Demonstrating the pervasiveness of our unpredictable behavioral outcomes, Lo includes a wonderful anecdote about how an erroneous opinion by an expert came to be conventional regulatory wisdom, and which inevitably led to poor policy prescriptions. In light of this, his recommendation for smarter regulation and deeper understanding of complex financial systems seems optimistic. If only we could be more rational, we could both build a more robust system and profit from others’ irrationality. Alas, even adaptive markets seem somewhat doomed to adjust by (painful) trial and (costly) error.

Notwithstanding his well referenced hypothesis, the practicality of combining the best of low-cost diversified investing and market prediction into Lo’s proposed dynamic financial indices will limited. For individual investors, the same heuristics that produce the market imperfections will be the same ones they use in choosing their dynamic indices. Lo does partially acknowledge the challenge for professional investors, recognizing that they will need to shift their approaches dynamically. As with more traditional investment strategies, winning approaches are adopted by other market participants and profitable opportunities competed away – or in finance jargon, alpha becomes beta.

Lo’s work may be more a complement to EMH than a foundational hypothesis, but his book is still a thought provoking synthesis of both traditional and behavioral finance, and from a much different perspective than the behavioral work of Thaler, Statman, and Shiller. It should be read by all with an interest in the limitations of traditional theories and in exploring leading edge financial thought.

[Lloyd Downey · Rating 2 out of 5]

My review is not really of the whole book but of a Blinkist Summary. I'm using these summaries to help me absorb more new ideas in the time I have left. (Which is rapidly contracting). If a book summary especially appeals to me, then I might indulge by reading the full book. However, I've noticed a tendency for Blinkist Summaries to be made of books by very prolific authors who are clearly just writing for a bulk market (especially with the self-help genre). So my hopes for Blinkist books are not high.
This is really my first attempt for years with Blinkist and I thought the summary was pretty good. As I also have the full book I will attempt a cross check by reading it. I took some notes of what I thought were key points from Blinkist (that's a summary of a summary) and here they are:
The Efficient Market Hypothesis is the most widely accepted theory for how the market works.
In a nutshell, EMH theory suggests that the price of stocks, bonds and similar investment assets will always provide an accurate reflection of the health, profitability and general value of a company.
Since you can’t beat the market, the standard advice is to “join the market” by investing in long-term, low-risk index funds, or mutual funds, which comprise a collection of stocks that will remain more or less untouched over time.

Humans are reliably irrational in dealing with money.
People tend to be more concerned with avoiding losses than making gains, which means we will generally take greater risks in order to avoid those losses than we will to hit the jackpot.

Human behavior is shaped by our emotions and instincts.
Through extensive research, neurologists have concluded that dopamine plays a central role in causing people to take irrational risks. This is something that the gambling industry is well aware of, as slot machines are designed to keep dopamine levels pumping so that gamblers will keep at it even as their money disappears.
Unfortunately, when dealing with money and trying to make the right decisions, we’re often in a fearful state of mind and experience the heightened emotional state of panic that accompanies it. This, in turn, is how we end up making irrational mistakes and piling up avoidable losses.

Survival of the richest is the ultimate force behind competition, innovation and adaptation.
Even though the exact methods used by hedge funds are still kept secret, they were soon popping up everywhere.
This is the evolutionary nature of the adaptive market in action: a new, superior species is introduced and soon begins to multiply and dominate.

The Adaptive Market Hypothesis can be used to make better financial decisions.
After all, there are some markets that will go through downturns longer than any investor can reasonably expect to wait out. For example, the Japanese market crashed in 1991 and remained stagnant for the next 20 years, a period known as the “lost decades.”
However, in some cases like this, what’s known as a behavioural premium may arise. This is when the irrational action becomes the dominant train of thought and more investors start pushing to sell, thus adversely affecting the long-term value of the company. In this scenario, relying on the efficient market would be unwise.

Financial crises are the result of markets evolving without proper oversight.
Most financial crises are an example of what happens when a market changes faster than investors can adapt.

The Adaptive Market Hypothesis can cure more than just our financial system.
If the Adaptive Market Hypothesis can help us see what went wrong in 2008, can it perhaps also point us to a better way forward, with more reliable markets? What history tells us is that we need better legislation to help prevent greed and fear-based decisions from ruining and damaging our economy.
There’s no reason why the financial industry should remain synonymous with greed and selfishness when it could use its power for the good of all humankind. [At this point he seems to be floating off into fantasy land.....ok, noble sentiments but a far cry from the realities of the market]
For example, there could be a “CancerCures” fund, managed by a panel of biomedical experts and experienced healthcare investors. Within it could be 150 independent research projects
With 150 independent projects looking at a wide range of treatments, we can estimate a 98-percent probability that at least three of them would be successful.
[I wonder where he got this idea from.....seems both fairly ambitious and does not really suggest that a "cure" might result. Most of these sorts of treatments are of a pretty simplistic nature....like Do you get better outcomes by combining chemotherapy with radiation every third week instead of every fourth week.]

Final summary
We’re long overdue for a new approach to our financial markets, one that acknowledges the human flaws of those participating in the system and recognizes the great potential the system has to do good. This is what the Adaptive Markets Hypothesis attempts to provide by incorporating the evolutionary element of markets.
Interesting ideas but not really new and where he does come up with new ideas they seem rather fanciful to me. Two stars from me.

[Jad Malaeb · Rating 5 out of 5]

4.5/5

There's a hypothetical 'Great Divide' in the financial world - the quants and academics that uphold the Efficient Market Hypothesis, and the tinkerers who expend ludicrous sums of emotional, financial and mental energy to prove them wrong.

Through the Adaptive Markets Hypothesis, Lo provides a middle ground. The Adaptive Markets is not a replacement to the EMH, he says, but what it does do is provide an answer for when Homo Economicus is not Economicking. Yes, I made that word up. In essence, Lo argues that there's substantial evidence that at least some forms of the EMH holds true. Humans do indeed spend some time thinking about the best return for their risk, and they do rationally consider alternatives in investments. That said, there are so many holes in the way this decision making is thought to occur.

In a clever example, the author outlines that if man was truly rational and optimized every decision, then for a cabinet with only a few articles of clothing, it would take the careful consideration of many thousands of combinations to simply pick an outfit out for the day. We obviously rationalize, but we do not do so in the manner that the EMH proposes. We have faults, natural limits in how much we can compute and how much effort we are willing to expend to make a decision. And of course, there are emotions. During bubbles, crashes and financial crises, the rational man seems to have gone on holiday, and the Adaptive Markets tells us that, once again, it's our biological underpinnings ushering in the vacation.

Emotions govern our behavior and even our rational thought. Without fear, there is no risk management. Without greed, there are no bubbles. Without hope, there is no resilience during drawdowns. Our emotions work for us in many ways, and they work against us, too, causing the already well-documented examples of market irrationality, including crashes, bubbles and panics.

These 'obvious' contradictions were patched over by EMH proponents because, like Lo says, it takes a theory to beat a theory. Lo's response to that is the Adaptive Markets hypothesis.

Using evolution as a model, Lo argues that the market should be looked like as a giant ecosystem, where differing species fight for survival and dominance, fight or flight responses trigger radical actions and organisms respond to fear, greed and hope. In moments when emotions are highest, the rational man takes a holiday, and the holes in traditional economic assumptions start to drown Homo Economicus in a pool of contradictions.

There's a lot more to talk about in this book - it is packed with psychological studies, cool stories (one about how the stock market figured out the culprit for a NASA-based crash in minutes when it took the government 5 months), definitions for intelligence, suggestions for improving the financial world and bold predictions of achievable utopias.

But, as a trader, most of what I will take away are the following:

1 - The market is a competition with thousands of species interacting in a large ecosystem. the resource that ushers one into domination is information. Superior information turns you into an apex predator.

2 - Emotions are NOT your enemy. Without emotions, you would not be able to trade. Perhaps most importantly, you would not be able to manage risk without fear. Emotions, however, can override reason, which is why a plan and calmness are required to execute well.

3 - Know who you are playing against. All top traders have developed some kind of gauge on the market and its participants. In the meme stock frenzy, this knowledge became crucial in anticipating price behavior. From pg. 282, "Knowing the environment and population dynamics may be more important than any single factor model."

4 - Some edges exist because they are part of human nature. These edges are exploitable and practically timeless. However, superior information is required to unlock their potential.


This was an excellent read and perhaps a vindication of what many traders have understood intuitively. Predatory behavior, stealth and disinformation are all parts of the trading game, just like they are part of an ecosystem. Anyone who has seen a huge bid flash and then disappear right before it gets filled knows it's essentially the same thing as a Venus fly trap attracting a fly only to usher it to its death. Lo provides the robustness and academic forte to bring trading intuition into a more serious light.

[Giacomo Graziano · Rating 3 out of 5]

Some passages from the book in no particular order.

An “efficient” market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.… In an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices. 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.”

FFJR looked at the prices of 940 stock splits from January 1927 to December 1959 and found two unmistakable regularities: stock prices jumped up on the day that a split was announced, but showed no clear direction on the day the split actually occurred. The market rewarded stocks that split, presumably in anticipation of an increase in dividends, but the reward came almost instantly. When the split actually happened, on the other hand, the market couldn’t have cared less. FFJR concluded that stock prices fully reflected all available information on the day of the announcement of the stock split. It was yet another confirmation of the Efficient Markets Hypothesis and, by implication, yet another slap in the face to Wall Street practitioners. And adding insult to injury, FFJR also showed that this regularity couldn’t be exploited by trading on the announcement. Only inside information could give you an edge in the market, which would be illegal ...

From experiences like these, I know that the Efficient Markets Hypothesis is more than an impractical academic theory. The wisdom of crowds does exist, and thanks to Samuelson, Fama, Muth, Lucas, and many other economists, we now understand how the market provides it. Efficient markets are powerful, practical tools to aggregate information, and they do it more quickly and cheaply than any known alternative.

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. If you use a defective bathroom scale that’s biased upward, averaging your weight across multiple readings on that scale won’t give you a more accurate measure of your weight. In the case of irrational investor behavior, the errors can compound across individuals, replacing the wisdom of crowds with the madness of mobs.

“Anecdotes are not data!”

With sufficient repetition, the action associated with the dopamine release becomes habit. In the case of cocaine, we call it an addiction. In the case of monetary gain, we call it capitalism. Our most fundamental reaction to monetary gain is hardwired into human physiology. Apparently, we know it instinctively: greed is good.

From a neuroscientific perspective, emotions help to form an internal reward-and-punishment system that allows the brain to select an advantageous behavior. From an economic perspective, emotions help to provide a basic currency or standard of value for animals—again, including humans—to engage in a cost-benefit analysis of the various options open to them.

Most of us can easily detect the difference between a natural smile and a forced smile.7 How? The answer lies in the way the brain is organized. A natural smile is generated by one region of the brain—the anterior cingulate cortex—and it involves certain involuntary facial muscles that are not under conscious motor control. A forced smile, however, is a purely voluntary behavior originating from the motor cortex of the brain. It’s not the same as a genuine smile, because the involuntary muscles of the face don’t participate...

Under the Adaptive Markets Hypothesis, individuals never know for sure whether their current heuristic is “good enough.” They come to this conclusion through trial and error. Individuals make choices based on their past experience and their “best guess” as to what might be optimal, and they learn by receiving positive or negative reinforcement from the outcomes.

Like Herbert Simon’s theory of bounded rationality, the Adaptive Markets Hypothesis can easily explain economic behavior that’s only approximately rational, or that misses rationality narrowly. But the Adaptive Markets Hypothesis goes farther and can also explain economic behavior that looks completely irrational. Individuals and species adapt to their environment. If the environment changes, the heuristics of the old environment might not be suited to the new one. This means that their behavior will look “irrational.” If individuals receive no reinforcement from their environment, positive or negative, they won’t learn. This will look “irrational” too. If they receive inappropriate reinforcement from their environment, individuals will learn decidedly suboptimal behavior. This will look “irrational.” And if the environment is constantly shifting, it’s entirely possible that, like a cat chasing its tail endlessly, individuals in those circumstances will never reach an optimal heuristic. This, too, will look “irrational.”

Few of us are capable of understanding fifth-order theories of mind consistently or looking more than five moves ahead in a chess game. And very few of us are able to compute economic optimizations in our head. Our rationality is clearly bounded...

By estimating the alphas and betas of financial investments, we should be able to construct passive, highly diversified portfolios of stocks weighted by their market capitalization to achieve reasonably attractive returns. (What does “reasonably attractive” mean here? An expected return that’s consistent with the portfolio’s beta.) Alpha seems rare—how many David Shaws do you know, and how easy is it to identify them before they become wildly successful and retire? The statistics support this intuition. Most portfolio alphas are small and statistically indistinguishable from zero. Therefore, let’s just focus on beta. Mathematically speaking, a passive portfolio is one that contains only beta, no alpha. These portfolios will be long-only, that is, never sold short in pursuit of excess profit, and they will charge much lower fees because you don’t need to pay for managerial talent; you’re paying for someone to implement Sharpe’s formulation, which is public knowledge.

... Grossman and Stiglitz’s insight that if markets were perfectly efficient there would be no motive for financial trading, so markets can never be perfectly efficient.

...the American economist Frank Knight who taught us how to separate risk from uncertainty. Risk is measurable and quantifiable; uncertainty is the unknown unknowns.

[InvestingByTheBooks.com · Rating 4 out of 5]

Due to the immense influence of Paul Samuelson economics in the mid twentieth century adopted much of the mathematical and statistical methodology of physics. The economic theories became all-explaining, exact and mathematically beautiful - but wrong. Starting in the 1980s a bunch of half-economists and half-psychologists emerged and formed the sub-discipline behavioral economics and were rude enough to point to the inaccuracies. Still, these new guys had no real alternative economic system to offer. They could tear down what was foul but had little ability to build anew. “It takes a theory to beat a theory” to speak with Milton Friedman. Then the Hong Kong born Andrew Lo, one of the more free-thinking economists of our age, a Professor at MIT and chairman of the hedge fund AlphaSimplex, launched a theory that it might actually be concepts from biology that will fit both traditional economics and behavioral economics into one unifying grand scheme. The framework became known as the adaptive market hypothesis (AMH) and it is the topic of this important book.

Broadly the book is structured so that chapters 1 through 5 give the reader background knowledge of the efficient market hypothesis of traditional finance, behavioral economics, neurofinance and biology’s evolutionary theory. Then chapters 6 to 8 present and exemplify the AMH. Finally, the last 4 chapters try to show that financial crises could be understood through the AMH and how we by this could form regulation and practices to if not prevent a crisis, at least stop it from escalating into something more severe.

Lo is a very good storyteller with a fair dose of humor. My only big complaint of Adaptive Markets is that it’s too comprehensive and thorough. The first 175 pages give necessary pieces of the puzzle so that the reader can understand Lo’s theory, but the reader probably hasn’t bought the book to read exactly these long sections on the basics and history of economics, psychology, biology etc. – we want the juicy stuff; the AMH. Then in chapter 9 there are another 30 pages giving a basic context behind the recent financial crisis. All in all these background stories are long enough to fill a normal length book by themselves. Although they clearly show the broad scholarship and knowledge of the author these sections should probably be cut in half for the second edition.

According to Lo price formation in markets follows the principles of evolution with its competition, adaptation and natural selection – or death - of spices in an ever changing environment. The spices in question are different groups of market participants that in a “satisficing” manner apply varying strategies and heuristics to compete for market profits. The choice of strategies are decided by an innovative (mutational) is interactive trial-and-error process, where the market feedback reinforces the use of some and deters the practice of other in an ever ongoing feedback loop towards refinement. A strategy that doesn’t fit the current environment would be deemed irrational by the traditional economist but is simply not adapted to the surroundings in an evolutionary meaning.

Now, unfortunately the environment isn’t static but depends on both external forces and the behavior of the competing spices. When too many populate the same habitat, i.e. uses the same strategies, the potential for profits is exhausted and a strategy that was well adopted becomes unprofitable, leading to a flight from the habitat. Eventually this exodus might restore the potential for returns and we get an ever oscillating market environment. An efficient market is simply a model of an unchanging market, something that only exists for so long. Interestingly, some “irrational” behaviors discovered by behavioral finance look to be unconsciously designed to spread one’s bets in case of change.

Anyone with an intention to have an edge in financial markets should really have read Adaptive Markets – because their competitors will have.