Adaptive Market Hypothesis

Interesting paper by Andrew W. Lo

From the Abstract:

The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and little consensus exists as to which side is winning or the implications 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 coexist 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.

Read the paper here

Trust Behavior: The Essential Foundation of Securities Markets

H/T to Simoleon Sense:

Here’s the most important lesson from this paper (via ssrn):

“This suggests another fundamental difference between rational expectations investors and trusting investors. Where the former look to “the shadow of the future,” the latter care about “the shadow of the past.” Put differently, a rational expectations investor expects others to exploit her whenever possible. Accordingly she will always be forward-looking, trying, just as a chess player might, to anticipate other players’ opportunistic future moves. In contrast, trusting investors look to the past. If someone or something has always behaved in a particular way in the past, trusting investors assume that that person or thing will continue to behave similarly in the future, without worrying too much about understanding what drives the behavior in question.”

Click Here To Learn About The Role Of Trust In Securities Markets

Abstract (Via SSRN)
Evidence is accumulating that in making investment decisions, many investors do not employ a ‘rational expectations’ approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like ‘the market,’ in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.

Great Introduction (Via SSRN)

Burt Ross graduated from Harvard University in 1965. After working several years as a stockbroker, he ran for and was elected mayor of Fort Lee, New Jersey. Then Ross turned to commercial real estate. In 2003, he decided to sell some of his buildings and invest the proceeds, which amounted to more than five million dollars. Ross thought he was prepared for retirement. At least, he thought he was prepared until December 11, 2008, when he learned that his nest egg–which he had invested almost entirely in funds managed by the now-infamous Ponzi schemer Bernard Madoff– was gone. (Pulliam, 2008)

Read the Paper Here

Can Irrationality Be Rational?

Barry Ritholtz responds to John Cassidy’s Rational Irrationality article:

(Cassidy’s analysis) asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong.

I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable — its NEVER rational.

Goldman Sachs avoided most of the credit debacle — were they being irrational when they forewent short term profits for a few years — but avoided the worst of the sub-prime debacle? And what about hedge fund manager John Paulson? His fund bet against all of these other players, netting several billions in profits while others suffered from their “Rational Irrationality.” How irrational was Paulson’s investment posture?

On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.

Great stuff from BR! Read the full post here

In Defense of Financial Innovation

Robert Shiller writing in the FT:

The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

Read the full article here

Predictably Irrational – How Investors Frame Decisions

Via Advisor Perspectives:

One of the most provocative sessions at Schwab Impact conference was given by Dan Ariely, who deftly summarized his current research in the important field of behavioral finance.  Ariely is a professor of economics at Duke University and a visiting professor at MIT’s Media Laboratory.  He is also the author of the popular book, Predictably Irrational.

Ariely’s message was that, no matter how good their intentions or how deep their experience, people – investors specifically – consistently make the wrong decisions.  They behave irrationally, and predictably so.

Advisors who understand the natural biases in individual behavior can frame questions that will steer their decision-making process in a more rational – and economically better – direction.

Read the full article here

Economists Need to Study Bubbles, Reinvent Models

A great editorial by Robert Shiller:

The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.

You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. As the statistician Leonard “Jimmie” Savage showed in 1954, if people follow certain axioms of rationality, they must behave as if they knew all the probabilities and did all the appropriate calculations.

So economists assume that people do indeed use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. They are not influenced by anything but the facts, and probabilities are taken as facts. They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed.

Abundant psychological evidence, however, has now shown that people do not satisfy Savage’s axioms of rationality.

Read the full article here

Eight Mental Traps to Avoid

This is a great article by Paul Larson of Morningstar.com on how investing is as much an exercise in controlling emotions as harnessing the intellect. Mr. Larson covers eight emotions. I provide a summary here:

Anchoring
Anchoring is the act of latching on to a given piece of information and using that as a point of reference for making decisions. Unfortunately, many investors anchor on things that are irrelevant to a business’s value, such as their own personal cost basis in a given stock or the 52-week trading high. Rather, we should focus on the thing that matters the most, the estimated future cash flow of a company.

Availability Bias
This mental shortcut concerns the relative importance of information. The importance our minds attach to information is correlated to how often we see the information. If we see and think about something often, our brains attach greater importance to it.

Endowment Effect
People place a higher value on things that they already own than things they do not own. Meaning, we would sell our possessions at a much higher price than at which we would buy the very same possessions if we did not already own them.

Sunk Cost Aversion
Sunk costs are costs that cannot be recovered once incurred. Once something is paid for in either time or money, our instinct is that we must soldier on and get some benefit for the expense, lest we feel like we are wasting resources. This is a variation of loss aversion, which is a concept that says people feel the pain of a loss at double the magnitude they feel the pleasure of a gain of the same amount. Two tips here. First, if a stock is clearly worth far less than what we originally paid for it, we should be willing to sell if today’s price is above our estimate of current value; that we are realizing a loss should be irrelevant to the decision. Second, if we spend several hours to research a given opportunity, we should still be willing to walk away. Our instinct will be to like the opportunity since we just spent time on it, but our goal should be to have rationality outweigh instinct.

Herd Behavior
Our deepest instincts tell us that there is safety in numbers. Beyond having a desire to do what is perceived to be socially acceptable, we often believe others have useful information from which we can take cues. After all, we all like to be liked, and the bigger group may know something we don’t. Simply, if “everybody’s doing it,” we feel the pressure to take that same action, whatever it may be. Plus, with investing being an activity where having incomplete information is the norm, this instinct to take cues from others can be amplified.

Recency Bias
We live in the here and now, and the ability to contemplate things far in the past and/or future is a uniquely human ability that requires higher cognitive functions. Yet our instincts can still get the better of us on occasion. Recency is the tendency to weigh recent events much more heavily into our decision-making than more distant events. It is a sort of mental short-sightedness where we think much more about our current situation than the much broader historical perspective. This can cause us to assume that the current state of the world–good or bad–persists into the future, rather than reverting to a long-run mean.

Confirmation Bias
Our brains inherently do not like conflict; they prefer to have a consistent, harmonious view of the world. They are wired to avoid cognitive dissonance–having two different ideas that are incompatible with each other. Our instinct is to search out information that confirms our existing views, accepting data that plug neatly into our preconceived biases, while rejecting data that do not support what we already think. Information that is consistent is processed more easily and does not increase stress.

Overconfidence
It’s an unfortunate fact that people tend to believe that their skill level is much higher than what it is in reality. For instance, the vast majority of drivers believe their driving ability is above average, even though this is statistically impossible. Unfortunately, Lake Wobegon is but fiction, and there is not a place where “all the women are strong, all the men are good-looking, and all the children are above average.”

This positive illusion we carry about ourselves allows us to be, as the famous book is titled, “Fooled by Randomness,” and attribute positive outcomes to our personal skills rather than luck or a trend over which we really had no control. Overconfidence can help us get through the stresses of our lives, but it can be deadly in the world of finance by causing one to overplay his or her hand.

Read the full article to learn more about each emotion

Related: Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics

Wall Street’s Math Wizards Forgot a Few Variables

From the NYT:

IN the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. They, after all, invented the exotic securities that proved so troublesome.

But the real failure, according to finance experts and economists, was in the quants’ mathematical models of risk that suggested the arcane stuff was safe.

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.

That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.

“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”

In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.

The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.

Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets. A team of six economists, finance experts and computer scientists at Cornell was recently awarded a grant from the National Science Foundation to pursue that goal.

“The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets,” explained Jon M. Kleinberg, a computer scientist and social network researcher at Cornell.

Read the full article here

Montier: Seven Sins of Fund Management

Via SSRN. This is an interesting paper from James Montier that outlines what he considers to be the seven sins of fund management.

From the summary:

How can behavioural finance inform the investment process? We have taken a hypothetical ‘typical’ large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.

► This collection of notes aims to explore some of the more obvious behavioural weaknesses inherent in the ‘average’ investment process.

► Seven sins (common mistakes) were identified. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

► Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

► Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

► Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

► Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months! This has nothing to do with investment, it is speculation, pure and simple.

► Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

► And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioural panacea. In general, they amplify rather than alleviate the problems of decision making.

► Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioural biases.

You can read the paper here.

Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

Read more »