Chapter 5: Andrew Lo: “The Only Part of Economics That Really Works”

Ø Lo looks at finance through a prism in which the theory of finance itself is just one element. He blends finance with a combination of economics, mathematics, the physical sciences, history, and evolutionary biology, as well as sociology and psychology.

Ø Lo aware that institutions play a strategic role in the whole story.

Ø By changing how people looked at markets, EMH has transformed the daily turmoil of the marketplace, and what seemed like an incomprehensible set of theoretical issues, into a relatively simple set of concepts.

Ø To Lo, the trouble with EMH is less with the story itself than with the way many academics have forgotten how these abstractions came from the real world of tumult and confusion in the capital markets.

Ø Lo deplores the way today’s economists believe they do not have to know any history.

Ø Lo: “Economics in the real world owes more to history than to abstract theory… Economics is not a science. History matters in trying to understand and apply it.”

Ø To Lo, EMH pond has been fished out. Behavioral approach is frustrating as well; as these findings are only a collection of anomalies, not a real theory. You need a theory to beat a theory.

Ø Investors are not the automatons of the EMH. They differ in countless ways from one another and, more important, they differ from one another and even themselves across time.

Ø Lo: “I finally decided that markets don’t really follow random walk. The notion is great idealization but not the real thing. And this work got me tenure at MIT!”

Ø Now human behavior and the impact of past experience combine with the rigors of mathematical and scientific analysis to compose the motivating forces in all Lo’s work. The central concept is the notion of change, of dynamics.

Ø In order to survive, species adapt their biology as their environment shifts. Those species that can adapt win out and are the survivors (Charles Darwin, The Origin of Species).

Ø Lo’s Adaptive Market Hypothesis à there is a parallel process of evolution and change at work in the capital markets.

Ø The development of human institutions is contingent on the goals or purposes that motivated their establishment in the first place.

Ø Institutions are a result of trial-and-error, where perfection is impossible, something less-than-perfect can often suffice.

Ø Institutions change as a result of purposeful decisions by the human beings who make use of them, but institutions also change in response to the forces of evolution.

Ø Only those who can continually adapt to the changing environment will make it. Only those who continually innovate can maintain an edge. These kinds of phenomenon are hard to analyze from an EMH viewpoint, but they do lend themselves to analysis from a biological perspective.

Ø Lo: “When I was teaching investments without actually having done it, I felt more like a voyeur than a real professor.”

Ø I really teach differently now – most of all, I teach students to be skeptical of everything. The answers they seek may be in the EMH or portfolio theory or diversification, but not necessarily.

Ø Gottfried von Leibniz’s: “Nature has established patterns originating in the return of events, but only for the most part.”

Ø No model has an R2 of one. Certainty in response to questions does not exist.

“But only for the most part” + “but not necessarily” à explains why there is such a thing as risk in the first place.