Market Efficiency from an Evolutionary Perspective
I missed this article when it first came out, but Andrew W. Lo’s “Market Efficiency from an Evolutionary Perspective” is fascinating and readable. The abstract:
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.
I’m sympathetic to the authors’ overall gist, but I noticed in my quick read of the paper that it offers no testable hypotheses. Anybody can tell a story that is consistent with the experimental data, after all. Personally, I’m heartened by the revelations that functional MRI has provided about what brains actually do when people make economic decisions. We may be seeing a synthesis of rather astounding dimensions, but it will be a long time coming I suspect.