Curious where finance theory will be in the 21st century? Adaptive Markets by Andrew Lo is an insightful read about one of the options. According its author, researchers will gain insight from evolutionary biology, neuroscience and genomics, and will likely construct a new model of a stock investor.
This new model of the stock investor will no longer rely on the rational assumptions of the past decade. In the future, we will place little weight on demand and supply curves to determine prices. And we will finally get rid of the presupposition (read: myth) that the stock investor makes an investment decision based on all relevant and material information.
New insights into the investor mindset may prove to be revolutionary. Future researchers will diagnose investment bubbles before they pop (it sure would help current Fintech investors), or using insights from psychology, the researchers may be able to prevent malicious acts, such as Ponzi schemes (read: the Bernie Madoffs of our investing world) by understanding what drives immoral behavior. And, perhaps, we will finally be able to use the great invention of finance for the wellbeing of the greater society, as described in the last chapter of this optimistic book.
But it takes great effort to reach the concluding chapter. It must have been important to Mr. Lo that the reader not only will know where finance research is heading, but also where it has been, and so the reader is expected to navigate - and to find interesting - the following myrid topics:
· From neuroscience, topics such as how the prefrontal cortex of the brain works
· From neoclassic economics, topics about efficient market theory
· From finance theory, topics about Random Walk Hyporhesis
From succinct to confused
Mr. Lo, a quantitative finance researcher at MIT, explains financial concepts with ease and clarity. For example, in the following paragraph, he explains the purpose behind the modern index:
“We can identify at least two distinct functions of a modern index. The first is largely informational. An index provides a quick and easy measurement of aggregate investment performance, separate from the outrageous fortunes of any individual component, to highlight the economy-wide driver of the market. This was the original function of an index in the 1880s, and it remains the reason why indexes are widely reported even today. The second function, however, is the more practical one for an investor: to act as a standard against which active managers can be compared, and as an investable alternative if those managers fall short.
His description of the scientific method is also praiseworthy:
“Nevertheless, for most forms of scientific inquiry, we can break the scientific method down into four phases. First, we gather the empirical evidence (this is especially difficult in economics, which historically has had either too little data, as in macroeconomics, or overwhelming oceans of data, as in financial economics). Second, we form a hypothesis. In effect, these are narratives that are candidates for explaining the data. Third, we make predictions with this hypothesis, which is the fourth and final phase tested experimentally.”
But I wish he would have asked experts in their field to explain fundamental concepts outside of his realm of expertise. Instead, we are left with his bold attempts to explain philosophy and biology, which I found to be tedious. For example, on the topic of morality, he writes:
“Our sense of morality is an adaptation to the environments of the past: our past history, our past culture and our past biology. These adaptations have made cooperation and collective intelligence possible, as well as ultimately improving reproductive success. Our morality may change with the times, but we have this core sense of fairness that was evolutionary hardwired into our brains millions of years ago.”
Here is another illustration:
“Natural selection, the primary driver of evolution, gave us abstract thought, language and the memory-prediction framework, new adaptations in human begins that were critically important for our evolutionary success. These adaptations have endowed us with the power to change our behavior within a single lifespan, in response to immediate environmental challenges and the anticipation of new challenges in the future.”
Is our natural behavior praiseworthy?
The basic premise of the book is that we are all driven by our survival instincts and that because our environment changes, so does our behavior. In other words, to understand the investor is to understand his or hers anatomy and his or hers environment. And the ultimate goal is to understand our nature.
But in my oipinion the focus should be on what is unnatural.
Take events from World War II as an illustration. It should be obvious to you that the natural behavior of many households was to shut their doors to refugees (as any other behavior would have surely risked theat household). And now, about 70 years after, do we admire the households who did what was natural?
No. We admire the families and individuals who did the unnatural, the improbable. Read Life in a Jar: The Irena Sandler Project, where you will encounter a Polish Catholic social worker that rescued over 2,500 Jewish children. Or read The Banality of Goodness: The Story of Giorgio Perlasca, the story of one individual who saved thousands. Or read the story of Frank Foley, titled Foley: The Spy Who Saved 10,000 Jews, written by Michael Smith.
The actions that are unnatural to us are often the most interesting, the most heroic and the most praiseworthy ones. I wish researcherers would focus on the unnatural more.