“Inherited biases seriously undermine our ability to perform accurate risk
management, because we instinctively spend more time and effort concerned
with scenarios that may actually have a lower chance of happening.”
our understanding of markets. Behavioral brains evolved to mainly worry about things that are most likely
economists have developed replacement to harm us. And while natural selection picked people with
theories, such as Professor Andrew Lo’s these traits over those without them, today these inherited biases
Adaptive Markets Hypothesis, that are seriously undermine our ability to perform accurate risk
gaining acceptance. Lo’s approach management, because we instinctively spend more time and
incorporates practical lessons from eff ort concerned with scenarios that may actually have a lower
behavioral economics and evolution to chance of happening.
provide a much more realistic model – one Furthermore, we may ignore those scenarios that are
that assumes, for example, that individuals actually more relevant and may be more likely to cause
not only make mistakes from time to time, fi nancial loss. Th e lessons are clear: we should be very careful
but that they also learn and adapt to in estimating the likelihood of extreme events and in
changing situations. determining which ones to concentrate on. We should
He has even adapted mathematical consider a healthy mix of those loss scenarios we naturally fear
tests that show the folly in specifi c EMH and those we naturally dismiss.
assumptions and turned them into tools
that provide penetrating risk- COMPLEX SYSTEMS
management analysis – like the possibility Complexity science, researched by places such as the Santa Fe
of detecting fraud just from a manager’s Institute, explains how quasi-independent agents exhibit
historical returns. collective behaviours that are impossible to deduce from the
Recent discoveries in seemingly agents’ individual motives and actions – bee swarms, cities,
unrelated fi elds – complexity science, multi-cellular life, fi nancial markets and whole economies are
emergence, cognitive science and evolution all examples of complex, adaptive and emergent systems.
– are infl uencing the next generation of Complex systems have some important characteristics with
economists. In addition to the studies implications for economics and markets – one of the most
mentioned earlier, cognitive science has led signifi cant of which is the presence of positive feedback loops.
to better understanding of how we Unlike negative feedback loops (such as thermostats) which
perceive risks and rewards. For example, dampen the eff ects of vibrations or sudden shocks and preserve
Tversky and Kahneman observed that an equilibrium, positive feedback loops (such as a microphone
people naturally assign a higher likelihood too close to a speaker) reinforce vibrations and sudden changes
to scenarios that are defi ned with more and can result in signifi cant amplifi cation, like fi nancial bubbles.
detail, even though such events are actually Oscillations are another common feature of complex systems
less likely to occur. – suggesting that economies may never actually reach any form
of equilibrium as assumed by the effi cient markets hypothesis
HUMAN BIASES and that boom-bust cycles may well be an inherent and
Humans also tend to overweight the unavoidable part of the process. Importantly, complex systems
probabilities of events that are similar to not only demonstrate volatility, they fundamentally require
ones we have personally lived through. For uncertainty and volatility in order for them to exist in the fi rst
example, how many times have we heard place. In other words, economies and markets probably do not
pundits explain the severity of the fi nancial tend towards an equilibrium price as described by supply and
meltdown with words like “in all my years demand doctrine, but rather they demonstrate continually
in the markets, I’ve never seen anything volatile price movements around a moving target.
like this before”, as if only those things we All of these recent discoveries stand in direct contrast to the
have already seen are reasonably likely to tenets of the EMH, and together they are forming the basis of
have ever occurred or occur in the future. new and exciting approaches to understanding economies and
Th e origins of these strong biases lie in markets. Unfortunately, these fi elds are still considered on the
the prehistoric environment in which our fringe in many university economics departments primarily
34 SUMMER 2009
32-3532-35 adaptive markets.indd 34adaptive markets.indd 34 1/6/091/6/09 11:56:0511:56:05Professional Investor Summer 09.36 36 4/6/09 15:40:59
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