Biology Key to Surviving Adaptive Markets, Says Lo

MIT finance professor Andrew Lo believes that there are factors that influence market movements in addition to those outlined in the efficient market hypothesis, according to an article in CFA Institute.

In a presentation at this year’s CFA Institute Fixed-Income Management 2018 Conference, Lo explained that, while the traditional investment framework is not wrong, it doesn’t take everything into account. “Markets behave much more like biological ecosystems rather than physical devices,” adding, “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.” Alternatively, he argues, a dynamic environment could yield dynamic investment policies.

“We are constantly observing our environment,” Lo told conference attendees, “looking at risks, and optimizing our Sharpe ration 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.”

Noting that human behavior doesn’t always correspond to reality, Lo asserted that human nature “draws us, like a moth to a flame, to high-Sharpe-ratio assets,” and that commonly accepted risk/reward tradeoffs don’t necessarily apply over shorter time frames (he provided examples from the 1930s, 1950s and 1970s when high volatility accompanied low average returns).

By identifying these tendencies, Lo believes investors can “adapt to the adaptations of others, ” and that It’s possible for investment professionals to engage in active risk management without necessarily being active portfolio managers. “We need to break that link,” according to Lo, who noted that today’s technology allows for active risk management “while remaining skeptical about the existence of alpha.”