26 May 2017
Andrew Lo specializes in derivatives. What he does not know about them is really not worth knowing. Funny thing is, there isn’t one sentence in this book about derivatives. A very highly-regarded author and academic has written a book about the physiology of fear, the experiments of Danny Kahneman, the chemistry of pleasure, Charles Darwin, quantum mechanics, but not his subject of expertise.
Once upon a time, many good (and other not-so-good) people believed that the role of derivatives was to “complete the market.” So, for example, if you “short” the stock of a company via a put option, by construction a feature is built into that put option that in the market is called a “stop-loss:” You cannot possibly lose more than the “premium” you paid to buy the put. A guy who borrowed the stock and sold it on margin can in theory lose an infinite amount of money if the trade goes against him. You can’t.
Such a “stop loss” does not grow on trees. It does not exist in nature. So this is a way in which a put option “completes” the market for trading in the stock of this company. You can now gain negative exposure to the stock of this company in a manner that was previously not available. If the market in the stock of this company gaps up (for example, doubles) without trading the prices in between at which it would have been necessary to buy the stock back to enforce a “stop-loss,” that is somebody else’s problem. Not yours.
That is but one example of many where derivatives “complete markets.”
People like Andrew Lo spend their time as academics examining, understanding and explaining to others how these constructs work.
Sadly, while derivatives do indeed complete markets, that’s not at all how we use them. Derivatives, 99.9% of the time are entered into by end-users for much more prosaic reasons. A poor guy who cannot borrow money can use them to obtain otherwise unobtainable leverage. A fund manager in Orange County who fancies himself the next George Soros can use them to circumvent his mandate. A country like Greece can use them to legally move its debt “off balance sheet” to meet the Maastricht criteria. An investment bank like Goldman Sachs can buy them from other counterparties of AIG to hedge against the potential demise of… AIG. (Sorted!) And so forth.
Which leaves academics that study derivatives in a funny place. They teach PhD’s about derivatives and then these guys, clutching their diplomas, mostly go to work in “risk,” a function within a financial institution whose chief role is to devise excuses for why whatever trade the boss wants to do fits within his mandate. Or alternatively, they function as the “fall guys” if something goes wrong, because their job description was to rubber-stamp whatever strategies or procedures went wrong.
This does not mean financial economists know nothing. They know a whole lot. And they come in contact with loads of movers and shakers. And at least they understand deeply, at the formula level, the mechanics of the instruments that are causing many of our problems in finance today. It’s just that finance theory, per se, is at right angles to the solution of our problems, precisely because financial innovation is not used in the way that is predicted by finance theory.
To put it differently, if I use a thousand dollar fountain pen to stir my coffee, the senior engineer at Montblanc may not be a guy with knowledge relevant to my life. If everybody uses his thousand dollar fountain pen only to stir his coffee, the senior engineer at Montblanc is entirely surplus to requirements. Except, of course, if he’s friends with all the guys who buy his pens, knows their stories and can tell you how they all go about stirring their coffee (assuming you care to know).
And that’s what we’ve got here:
Hot on the heels of Richard Bookstaber’s “The End of Theory,” (whose previous book, incidentally, he trashes by implying its “high complexity” and “tight coupling” theory is cribbed from a 1984 book by an author called Charles Perrow), Andrew Lo has written a book that not only
1. explains that there is no such thing as a “homo economicus” who always correctly and rationally computes the best course of action for his economic life, but also
2. proposes an alternative way to explain the world
The fundamental insight is that economic agents (you and I) are driven by behavior that is pre-programmed into us by evolution. Andrew Lo’s conclusion is that this behavior must by nature be adaptive, because that is the type of behavior that evolution rewards. That is the “Adaptive Markets Hypothsis.”
The author does not get there fast. What we have here is a tremendously entertaining, witty, often wordy, but never boring tour of the natural sciences and how the author thinks they pertain to man’s attitude to risk and uncertainty.
Does it add up?
For me, it doesn’t.
I’ve spent 25 years trading, for a good 8 or 9 institutions and I promise you that if anybody thinks past year-end he will trade in a manner that will get him fired. Hell, you probably should not think past month-end if it’s a career in finance you want. How on earth that individual behavior somehow conspires to add up to collective behavior that becomes adaptive, and how anybody can think that when all we observe around us is stuff like Bitcoin trading at 2000 is beyond me.
I guess Andrew Lo is saying we should behave adaptively. But the observation that when things are calm homo economicus is a good model and when all the little pockets of value have been arbed all bets are off is resolutely not the same as saying the adaptive model is the one that should guide a market observer in the small. Rather, you need to do what Chuck Prince said and dance when the music is playing. I would contend that Warren Buffet is doing no different, but has the deep pockets and corporate structure to not get killed when the dance floor gets slippery…
And yet, for me “Adaptive Markets” was pure entertainment. If the book was 800 pages rather than 400 I would have read it anyway, because I had a super time reading it. There are tons of fun things here that have nothing to do with markets, but were a joy to read and think about. Like, I finally found out what “New Math” was and I’ll order the books for my kids. Or there is a treatise on what it means to be intelligent (Andrew Lo’s answer: the ability to put together good narratives) Stuff like that, which I totally loved.
There’s also some annoying stuff for geeks like me. For instance, despite explaining toward the end of the book exactly how positive feedback can get a microphone to squeal, the author does a solid impression of an HR lady at the beginning of the book when he keeps discussing “positive feedback” and “negative feedback” in the context of how people answer surveys. Sloppy.
So that’s really it. A hyper-wordy book, a whirlwind tour of all departments at MIT, I guess, from sociology to psychology to neurobiology, with stops to take pictures of the 2007 quant meltdown and the 2010 flash crash, best exemplified by the rather facile explanation of prospect theory (it’s because of the amygdala, who is not a character in Star Wars, read to book to get the scoop), but a tremendous read if you are a nerdy guy like I am.
If, unlike me, you are not a dweeb, you should probably skip, though.