Why Animal Spirits Can Cause Markets to Break Down2009
The push for financial regulatory reform has highlighted an important debate surrounding the Efficient Markets Hypothesis, the idea that market prices are rationally determined and fully reflect all available information. If true, the EMH implies that regulation is largely unnecessary because markets allocate resources and risks efficiently via the "invisible hand". However, critics of the EMH argue that human behaviour is hardly rational but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehavior.
When the Wisdom of Crowds Becomes the Madness of Mobs2009
In this opinion piece, MIT Sloan Prof. Andrew Lo writes, “The world has become more complex over the past 20 years, and we need to update our investment paradigm to incorporate these new complexities... To achieve true diversification, investors must now have a broader set of asset classes and risk exposures, long and short, in their portfolios.”
Radical Reform of Executive Pay2009
The recent proposal by the Fed to regulate bankers’ compensation practices is understandable given the events of the past two years, but setting caps on salaries and bonuses misses the fundamental problem of compensation on Wall Street. Despite the public resentment surrounding finance-industry payouts, the fact is that no one objects to paying for performance. We just want to make sure we’re not getting fleeced or paying for pure dumb luck, and this is where the problem lies.
Regulatory Reform in the Wake of the Financial Crisis of 2007-20082009
Financial crises are unavoidable when hardwired human behavior—fear and greed, or "animal spirits"—is combined with free enterprise, and cannot be legislated or regulated away. Like hurricanes and other forces of nature, market bubbles and crashes cannot be entirely eliminated, but their most destructive consequences can be greatly mitigated with proper preparation. In fact, the most damaging effects of financial crisis come not from loss of wealth, but rather from those who are unprepared for such losses and panic in response. This perspective has several implications for the types of regulatory reform needed in the wake of the Financial Crisis of 2007-2008, all centered around the need for greater transparency, improved measures of systemic risk, more adaptive regulations including counter-cyclical leverage constraints, and more emphasis on financial literacy starting in high school, including certifications for expertise in financial engineering for the senior management and directors of all financial institutions.
Efficient Markets Hypothesis2008
The Efficient Markets Hypothesis (EMH) refers to the notion that market prices fully reflects all available information. Developed independently by Paul A. Samuelson and Eugene F. Fama in the 1960's, this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. The most enduring critique comes from psychologists and behavioral economists who argue that the EMH is based on counterfactual assumptions regarding human behavior, i.e., rationality. Recent advances in evolutionary psychology and the cognitive neurosciences may be able to reconcile the EMH with behavioral anomalies.
Survival of the Richest2006
In financial markets, as in many human endeavors, there’s a battle between reason and madness. On one side are the disciples of the efficient-markets hypothesis: the notion that markets fully, accurately, and instantaneously incorporate all relevant information into prices. These adherents assume that market participants are rational, always acting in their own interest and making mathematically optimal decisions. On the other side are the champions of behavioral economics: a younger discipline that points to bubbles, crashes, panics, manias, and other distinctly unreasonable phenomena as evidence of irrationality.
It’s hard to deny that investors act irrationally from time to time, yet behavioralists have so far failed to offer an alternative to supplant the efficient-markets hypothesis, which does brilliantly explain many economic occurrences and has had an enormous impact on modern financial theory and practice. Both approaches seem to have compelling explanatory power in their own right, yet they have opposing premises: rationality versus human psychology. How can the efficient-markets hypothesis and behavioral economics ever be reconciled? Perhaps by looking to Charles Darwin instead of Adam Smith.
Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis2005
The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and there is little consensus as to which side is winning or what the implications are for investment management and consulting. In this article, I review the case for and against the Efficient Markets Hypothesis, and describe a new framework—the Adaptive Markets Hypothesis—in which the traditional models of modern financial economics can co-exist alongside behavioral models in an intellectually consistent manner. Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants. Many of the examples that behavioralists cite as violations of rationality that are inconsistent with market efficiency—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, I show that the Adaptive Markets Hypothesis yields a number of surprisingly concrete applications for both investment managers and consultants.
Fear and Greed in Financial Markets: A Clinical Study of Day-Traders2005
We investigate several possible links between psychological factors and trading performance in a sample of 80 anonymous day-traders. Using daily emotional-state surveys over a five-week period as well as personality inventory surveys, we construct measures of personality traits and emotional states for each subject and correlate these measures with daily normalized profits-and-losses records. We find that subjects whose emotional reaction to monetary gains and losses was more intense on both the positive and negative side exhibited significantly worse trading performance. Psychological traits derived from a standardized personality inventory survey do not reveal any specific "trader personality profile", raising the possibility that trading skills may not necessarily be innate, and that different personality types may be able to perform trading functions equally well after proper instruction and practice.
The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective2004
One of the most influential ideas in the past 30 years of the Journal of Portfolio Management is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution—competition, adaptation, and natural selection—to financial interactions. By extending Herbert Simon's notion of "satisficing'' with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.
The Psychophysiology of Real-Time Financial Risk Processing2002
A longstanding controversy in economics and finance is whether financial markets are governed by rational forces or by emotional responses. We study the importance of emotion in the decision making process of professional securities traders by measuring their physiological characteristics, e.g., skin conductance, blood volume pulse, etc., during live trading sessions while simultaneously capturing real-time prices from which market events can be detected. In a sample of 10 traders, we find significant correlation between electrodermal responses and transient market events, and between changes in cardiovascular variables and market volatility. We also observe differences in these correlations among the 10 traders which may be systematically related to the traders' levels of experience.
Bubble, Rubble, Finance In Trouble?2002
In this talk, I review the implications of the recent rise and fall of the technology sector for traditional financial theories and their behavioral alternatives. Although critics of the Efficient Markets Hypothesis argue that markets are driven by fear and greed, not fundamentals, recent research in the cognitive neurosciences suggest that these two perspectives are opposite sides of the same coin. I propose a new paradigm for financial economics that focuses more on the evolutionary biology and ecology of markets rather than the more traditional physicists' view. By marrying the principles of evolution to Herbert Simon's notion of "satisficing,'' I argue that much of what behavioralists cite as counter-examples to economic rationality—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of rational agents learning to adapt to their environment via satisficing heuristics.
Artificial intelligence has transformed financial technology in many ways and in this review article, three of the most promising applications are discussed: neural networks, data mining, and pattern recognition. Just as indexes are meant to facilitate the summary and extraction of information in an efficient manner, sophisticated automated algorithms can now perform similar functions but at higher and more powerful levels. In some cases, artificial intelligence can save us from natural stupidity.
Agent-Based Models of Financial Markets: A Comparison with Experimental Markets2001
We construct a computer simulation of a repeated double-auction market, designed to match those in experimental-market settings with human subjects, to model complex interactions among artificially-intelligent traders endowed with varying degrees of learning capabilities. In the course of six different experimental designs, we investigate a number of features of our agent-based model: the price efficiency of the market, the speed at which prices converge to the rational expectations equilibrium price, the dynamics of the distribution of wealth among the different types of AI-agents, trading volume, bid/ask spreads, and other aspects of market dynamics. We are able to replicate several findings of human-based experimental markets, however, we also find intriguing differences between agent-based and human-based experiments.
Finance: A Selective Survey2001
Ever since the publication in 1565 of Girolamo Cardano's treatise on gambling, Liber de Ludo Aleae (The Book of Games of Chance), statistics and financial markets have become inextricably linked. Over the past few decades many of these links have become part of the canon of modern finance, and it is now impossible to fully appreciate the workings of financial markets without them. This selective survey covers three of the most important ideas of finance—efficient markets, the random walk hypothesis, and derivative pricing models—that illustrate the enormous research opportunities that lie at the intersection of finance and statistics.
A Non-Random Walk Down Wall Street1999
For over half a century, financial experts have regarded the movements of markets as a random walk--unpredictable meanderings akin to a drunkard's unsteady gait--and this hypothesis has become a cornerstone of modern financial economics and many investment strategies. Here Andrew W. Lo and A. Craig MacKinlay put the Random Walk Hypothesis to the test. In this volume, which elegantly integrates their most important articles, Lo and MacKinlay find that markets are not completely random after all, and that predictable components do exist in recent stock and bond returns. Their book provides a state-of-the-art account of the techniques for detecting predictabilities and evaluating their statistical and economic significance, and offers a tantalizing glimpse into the financial technologies of the future.