A Massachusetts Institute of Technology professor has written a book that asks — and answers — the question: Are financial markets efficient or irrational?
In “Adaptive Markets: Financial Evolution at the Speed of Thought,” Andrew W. Lo proposes a new framework of analysis called the adaptive markets hypothesis that points to the place where the opposing theories of modern financial theorists (“markets are rational and efficient”) and behavioral economists (“markets are irrational and inefficient”) converge.
Using research in evolutionary biology, psychology, neuroscience and artificial intelligence, Mr. Lo — the Charles E. and Susan T. Harris Professor at MIT's Sloan School of Management and director of the MIT Laboratory for Financial Engineering — explains how human behavior shapes the markets, leading to swings between stability and instability, profit and loss, innovation and regulation.
“Human nature is multifaceted. It has the capability for logical deliberation, but fear or greed can overtake rational thought. This can create market panic or market exuberance,” Mr. Lo said in an interview.
In his book, Mr. Lo posits that long-established economic theories are not wrong, but they fall short of explaining reality. In other words, investors should not be wedded to any one particular theory about the markets, but instead should understand how the nature of markets can change.