How the world of fi­nance evolves

We are bi­o­log­i­cal be­ings, and not as ra­tio­nal as we might think. What does this mean for our in­ter­ac­tion with mar­kets?

Finweek English Edition - - Opinion - By Jo­han Fourie ed­i­to­rial@fin­week.co.za Jo­han Fourie is as­so­ci­ate pro­fes­sor in eco­nom­ics at Stel­len­bosch Uni­ver­sity.

why do stock mar­kets tend to be de­pressed dur­ing win­ter? Why do in­vestors with too lit­tle emo­tional re­sponse (or too much) tend to be less prof­itable than those with just the right amount of emo­tion? Why do traders tend to make more money on days when their lev­els of testos­terone are higher than av­er­age?

In a fas­ci­nat­ing new book, An­drew Lo builds on the cor­pus of be­havioural sci­ence re­search to out­line a new the­ory of fi­nan­cial mar­kets. His ba­sic point: Homo eco­nomi­cus is dead. The hy­per-ra­tio­nal hu­man who al­ways op­ti­mised ev­ery de­ci­sion, most fa­mously por­trayed in the Ef­fi­cient Mar­kets Hy­poth­e­sis of Eu­gene Fama that has ruled the field of fi­nance at least since the 1980s, does not ex­ist.

Lo’s new book, Adap­tive Mar­kets: Fi­nan­cial Evo­lu­tion at the Speed of Thought, ex­pli­cates his Adap­tive Mar­kets Hy­poth­e­sis, first pro­posed in 2004 as a sub­sti­tute for the Ef­fi­cient Mar­kets Hy­poth­e­sis.

In short, the Adap­tive Mar­kets Hy­poth­e­sis ac­cepts that hu­mans are bi­o­log­i­cal be­ings, and that our bi­ol­ogy lim­its our abil­ity to op­ti­mise ev­ery de­ci­sion as the Ef­fi­cient Mar­kets Hy­poth­e­sis pre­dicts. Most im­por­tantly, though, our “ir­ra­tional­ity” is not ran­dom. This means that we con­sis­tently make the same “mis­takes”, some­thing that be­havioural sci­en­tists have known for quite some time. One of th­ese mis­takes, for ex­am­ple, is that we of­ten link events to­gether be­cause they hap­pen to oc­cur close to one another.

Lo ex­plains: “We hu­mans are not so much the ‘ra­tio­nal an­i­mal’ as we are the ra­tio­nal­iz­ing an­i­mal. We in­ter­pret the world not in terms of ob­jects and events, but in se­quences of ob­jects and events, prefer­ably lead­ing to some con­clu­sion, as they do in a story.”

Telling sto­ries is one way we try to make sense of the world, even if those sto­ries are some­times false. We do this be­cause, given the en­vi­ron­ments that we en­coun­tered, this was the most evo­lu­tion­ary suc­cess­ful be­hav­iour. But that has con­se­quences: If our environment change, our bi­o­log­i­cal de­ci­sion-mak­ing pro­cesses might not be equipped to deal with the new environment.

In Lo’s words: “‘Ra­tio­nal’ re­sponses by Homo sapi­ens to phys­i­cal threats on the plains of the African sa­van­nah may not be ef­fec­tive in deal­ing with fi­nan­cial threats on the floor of the New York Stock Ex­change.”

Of­ten the real world is not very dif­fer­ent from the sur­vival-of-the-fittest world our an­ces­tors en­coun­tered on the African plains. Many times, hu­mans do op­ti­mise their be­hav­iour. This is why the Ef­fi­cient Mar­kets Hy­poth­e­sis could hold for so long, treat­ing “ir­ra­tional” be­hav­iour as ran­dom out­liers that will be av­er­aged out in the mar­ket­place.

But as Lo demon­strates, of­ten hu­mans (and by im­pli­ca­tion traders) be­have “pre­dictably ir­ra­tional”, re­act­ing to fear sys­tem­at­i­cally dif­fer­ent than to re­ward, for ex­am­ple, and open­ing op­por­tu­ni­ties for wind­fall prof­its on the fi­nan­cial mar­kets. That’s why some fa­mous in­vestors, ac­count­ing for th­ese pre­dictably ir­ra­tional heuris­tics, can be con­sis­tently suc­cess­ful.

The good news is that we are not like other an­i­mals. We don’t have to wait for evo­lu­tion to mould us to our environment through nat­u­ral se­lec­tion. We have the abil­ity to learn and ad­just through trial and er­ror. High-fre­quency trad­ing is a great ex­am­ple: speed is every­thing in fi­nan­cial mar­kets, and au­to­mated trad­ing pro­grammes have re­placed spe­cial­ist hu­man traders who are just too slow to recog­nise and re­spond to the pre­dictably ir­ra­tional hu­man er­rors.

But even this is chang­ing, says Lo: “At first, th­ese high-fre­quency traders made wind­fall prof­its, since hu­man spe­cial­ists were slug­gish and in­ef­fi­cient in com­par­i­son. How­ever, there ul­ti­mately came a point where high­fre­quency traders were mainly com­pet­ing with one another. To suc­ceed in this fi­nan­cial arms race, high­fre­quency trad­ing firms had to in­vest in faster and more ex­pen­sive hard­ware.”

At the same time, how­ever, th­ese firms were scour­ing the mar­ket for any trace of “juice” that might be left. In a very short amount of time, high-fre­quency trad­ing was push­ing against its nat­u­ral evo­lu­tion­ary lim­its. It had un­ex­pect­edly be­come a ma­ture in­dus­try, with low mar­gins on trades and low over­all prof­its.

High-fre­quency trad­ing is now on the de­cline, as more and more ex­changes start im­ple­ment­ing “no high-fre­quency trad­ing zones”. The environment is chang­ing, and high-fre­quency traders who don’t adapt will per­ish.

The book ex­plains why the Ef­fi­cient Mar­kets Hy­poth­e­sis was so ap­peal­ing, why ear­lier at­tempts to use evo­lu­tion­ary think­ing in fi­nance never caught on, and what this new the­ory might say about the fu­ture of fi­nance.

It also has a cau­tion­ary word about how we train the next gen­er­a­tion of fi­nance gu­rus: “For the math­e­mat­i­cally trained econ­o­mist, it’s some­times dif­fi­cult to think in evo­lu­tion­ary or eco­log­i­cal terms, but sooner or later, this way of think­ing will be do­mes­ti­cated (another bi­o­log­i­cal metaphor), and will be­come another stan­dard tool for econ­o­mists to use, just as molec­u­lar bi­ol­o­gists use it to­day.”

Just like the fi­nance in­dus­try em­ployed math­e­mat­i­cally in­clined en­gi­neers and physi­cists in the past few decades, per­haps bi­ol­ogy will be the train­ing of choice for the next gen­er­a­tion of in­vest­ment firms. Per­haps. What we do know is that the environment is chang­ing, and that traders will have to adapt too if they are to sur­vive, and thrive. As Lo ex­plains: “An evo­lu­tion­ar­ily suc­cess­ful adap­ta­tion doesn’t have to be the best; it only needs to be bet­ter than the rest.” Let the games be­gin! ■

The Adap­tive Mar­kets Hy­poth­e­sis ac­cepts that hu­mans are bi­o­log­i­cal be­ings, and that our bi­ol­ogy lim­its our abil­ity to op­ti­mise ev­ery de­ci­sion as the Ef­fi­cient Mar­kets Hy­poth­e­sis pre­dicts.

An­drew Lo Pro­fes­sor of fi­nance at the MIT Sloan School of Man­age­ment

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.