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Adaptive Markets

Financial Evolution at the Speed of Thought

By Andrew W. Lo
15-minute read
Audio available
Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Adaptive Markets (2017) is about a new economic theory that helps us better understand the human element behind financial markets. Andrew W. Lo expertly illustrates the shortcomings of current prevailing economic theories, showing us how finance is less like physics or math and more like a responsive and evolving organism – not unlike ourselves.

  • Investors interested in finance and how the market works
  • Readers interested in the science of money
  • Students of economics

Andrew W. Lo is the director of the Laboratory for Financial Engineering at MIT and a professor at the MIT Sloan School of Management. He is also the chairman and strategist for the investment management company AlphaSimplex Group. Some of his writing on economics and investments can be found in his book Hedge Funds, as well as other books he has coauthored, including A Non-Random Walk Down Wall Street and The Economics of Financial Markets.

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Adaptive Markets

Financial Evolution at the Speed of Thought

By Andrew W. Lo
  • Read in 15 minutes
  • Audio & text available
  • Contains 9 key ideas
Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo
Synopsis

Adaptive Markets (2017) is about a new economic theory that helps us better understand the human element behind financial markets. Andrew W. Lo expertly illustrates the shortcomings of current prevailing economic theories, showing us how finance is less like physics or math and more like a responsive and evolving organism – not unlike ourselves.

Key idea 1 of 9

The Efficient Market Hypothesis is the most widely accepted theory for how the market works.

If you’ve taken an Economics 101 course, you’ve probably heard about the predominant theory about how the markets work: the Efficient Market Hypothesis, or EMH for short.

In a nutshell, EMH theory suggests that the price of stocks, bonds and similar investment assets will always provide an accurate reflection of the health, profitability and general value of a company.

In recent years, it’s become widely accepted that the EMH isn’t perfect, but academics and leading experts in the investment sector still regard it as the best theory out there.

To see the EMH in action, let’s look at the company Morton Thiokol, which helped make rockets for NASA in the 1980s, including the faulty piece of equipment that was found to cause the Challenger Space Shuttle explosion in 1986. It made perfect sense that the value of Morton Thiokol shares plummeted in the minutes following the Challenger disaster because the company had just encountered a serious setback.

The EMH works because it takes into account the collective wisdom of all the investors who are constantly analyzing the market and reflecting their best assessments of how well businesses will do in the price they’re willing to buy and sell their assets at. It’s generally agreed that by putting together all these active financial minds, you’ll get a fairly accurate reflection of a company’s value.

Now, given this high regard for the EMH’s accuracy, it is also considered highly unlikely that anyone can “beat the market,” which would involve spotting something that everyone else has missed. And since you can’t beat the market, the standard advice is to “join the market” by investing in long-term, low-risk index funds, or mutual funds, which comprise a collection of stocks that will remain more or less untouched over time.

By sticking with index funds for a long period, a patient investor can expect to take advantage of the stock market’s gradual increase in value over time. It was these standard principles of EMH that led John Bogle to create the Vanguard Index Trust, the first mutual fund, in 1976.

Since then, the index and mutual fund businesses have become a multi-trillion-dollar staple of the finance industry.

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