The Adaptive Markets Hypothesis: A Step in the Right Direction

In a conversation with the master jazz musician and Pulitzer Prize-winning composer Wynton Marsalis, he told me, “You need to have some restrictions in jazz.  Anyone can improvise with no restrictions, but that’s not jazz.  Jazz always has some restrictions.  Otherwise it might sound like noise.”  The ability to improvise, he said, comes from fundamental knowledge, and this knowledge “limits the choices you can make and will make.  Knowledge is always important where there’s a choice.” - The Art of Choosing, Sheena Iyengar

We have all been taught to “play by the rules” since the very beginning of our lives. Our parents did the best they could to teach us rules of proper behavior.  That list of rules continued to grow longer the older we got, governing our day to day interactions with others. However, each of us has learned that in many instances rules can and should be changed. It just takes an overwhelming amount of effort to do so, and leaves those attempting to enact that change open to bullying by the status quo.

Investment advisors, since 1940, have been subject to the legal rules established in the Investment Advisors Act, which spells out the fiduciary duties they have to their clients. Since then, the basis for these underlying fiduciary rules has not changed much. However, due to the rapid development of statistical analysis based on more powerful computer capabilities, academic finance has greatly changed what is today considered “correct and reliable” investment portfolio management rules. As a long time practitioner I have learned enough to know there are no reliable universal rules, and those willing to put complete faith in such rules will end up losing at some point.

One academic I have followed over the years is Dr. Andrew W. Lo, the Charles E. and Susan T. Harris Professor at MIT Sloan School of Management.  Most of his academic work in the world of finance is not something an average investor would enjoy, let alone comprehend, but for those who want to take on the challenge, I would recommend it.  For the rest of us, his book Adaptive Markets is full of stories with purpose and meaning that are easily understood by both professionals and non-professionals. 

Though I recommend the book, that does not mean I am in full agreement with his Adaptive Markets Hypothesis.  However I do take pleasure in knowing that there is someone of stature who is pushing for change in the status quo.  I want to highlight the principles Lo discusses in Chapter 8 of his book.  First, I’ll share his “Core Beliefs and Principles of the Traditional Investment Paradigm Spawned by the Efficient Markets Hypothesis.”  Lo says “These are the convictions held not just by finance professors, but also by investment managers, brokers, and financial advisers.” I agree that these are guiding rules for most in the investment world, though I hold myself out as an exception.

Core Beliefs and Principles of the Traditional Investment Paradigm

Principle 1:  The Risk/Reward Trade-Off.  There’s a positive association between risk and reward among all financial investments.  Assets with higher reward also have higher risk.

Principle 2:  Alpha, Beta, and the CAPM.  The expected return of an investment is linearly related to its risk (in other words, plotting risk versus expected return on a graph should show a straight line), and is governed by an economic model known as the Capital Asset Pricing Model, or CAPM.

Principle 3:  Portfolio Optimization and Passive Investing.  Using statistical estimates derived from Principle 2 and the CAPM, portfolio managers can construct diversified long-only portfolios of financial assets that offer investors attractive risk-adjusted rates of return at low cost.

Principle 4:  Asset Allocation.  Choosing how much to invest in broad asset classes is more important than picking individual securities, so that asset allocation decision is sufficient for managing risk of an investor’s savings.

Principle 5:  Stocks for the Long Run.  Investors should hold mostly equities for the long run.

The almost universal acceptance of these principles may actually have the opposite effect: lessening returns over time.  Take Principle 4, which emphasizes asset classes over individual securities.  This completely removes the investor’s connection of her investment to the very real operating business she owns, or the actual entity she is lending money to. By default, this could encourage speculation based more on fear and greed than on the fundamental relationship between price and value. 

Dr. Lo’s Adaptive Market Hypothesis attempts to address behavior.  Here is his “adaptive” approach to the above five principles.

The Five Principles of the Traditional Investment Paradigm
from the Perspective of Adaptive Markets

Principle 1A:  The Risk/Reward Trade-Off.  During normal market conditions, there’s a positive association between risk and reward among all financial investments.  However, when the population of investors is dominated by individuals facing extreme financial threats, they can act in concert and irrationally, in which case risk will be punished.  These periods can last for months or, in extreme cases, for decades.

Principle 2A:  Alpha, Beta, and the CAPM.  The CAPM and related linear factor models are useful inputs for portfolio management, but they rely on several key economic and statistical assumptions that may be poor approximations in certain market environments.  Knowing the environment and population dynamics of market participants may be more important than any single factor model.

Principle 3A:  Portfolio Optimization and Passive Investing.  Portfolio optimization tools are only useful if the assumptions of stationarity and rationality are good approximations to reality.  The notion of passive investing is changing due to technological advances, and risk management should be a higher priority, even for passive index funds.

Principle 4A:  Asset Allocation.  The boundaries between asset classes are becoming blurred, as macro factors and new financial institutions create links and contagion across previously unrelated assets.  Managing risk through asset allocation is no longer as effective today as it was during the Great Modulation.

Principle 5A:  Stocks for the Long Run.  Equities do offer attractive returns over the very long run, but few investors can afford to wait it out.  Over more realistic investment horizons, the chances of loss are significantly greater, so investors need to be more proactive about managing their risk.

As you read these Principles, I believe you will find merit in Dr. Lo’s adaptation.  I know I do, and I hope other academics will take up the cause and expand this research.  Principle 1A is one to take note of, as I believe it has particular merit today, although in opposite of what most of us would think.  We know that investors will act in concert irrationally during times of extreme financial threats; just think back to 2008 and early 2009.  Not only did individuals act irrationally, but a very large portion of institutions did the very same, joining the largest club of investors in the world, the Buy High Sell Low Club. 

Today I believe the next membership drive is about to start.  To be a member of this club you must begin with buying high.  Dr. Lo’s Principal 1A states investors will act irrationally due to financial threats, but the threat today is not a fear of losing money. In fact, it’s just the opposite; fear of not making any money when all your friends and peers are.  Wall Street affectionately calls this FOMO, or the “Fear of Missing Out.”

I have experienced this in previous bull markets.  We just hope this time it is not as disappointing as the last FOMO market in common stocks from 1998 to 2000.  The results were disappointing to those who jumped on the bandwagon late in the game. In the ten years beginning on January 1, 2000 and ending on December 31st 2010, the S&P 500’s annualized return, including the reinvestment of dividends, was just 0.36%.  We may have just seen the beginning of the next round of a FOMO market, or maybe it is just a false start.  Time will tell.

Until next time,

Kendall