Darwin goes to Wall Street

Since the financial crash of 2008 the field of economics has been in a state crisis, where a paradox lies at the heart of the issue.

On the one hand markets are remarkably rational and efficient, displaying allocation and foresight that prediction scientists are only beginning to fully grasp. Efficient markets are powerful, practical tools for aggregating information, and they do it more quickly and cheaply than any known alternative.

However markets also prone to wild swings of irrationality, and can fail spectacularly. Indeed, soul searching in the wake of the financial crisis has led to calls for the field of economics to be revolutionised. Behavioural economics has since risen in prominence, challenging the orthodoxy of neoclassical economic theory by outlining how predictably irrational people can be.

What can we make of this apparent contradiction?

In Adaptive Markets, MIT finance professor Andrew Lo ambitiously calls for a paradigm shift in financial economics, and urges us to reconsider financial markets from an evolutionary perspective. Lo argues by understanding the evolutionary forces that have shaped human behaviour and spurred financial innovation we can reconcile these paradoxical findings, and successfully address the problems facing the financial world.

It Takes a Theory to Beat a Theory

One passage from the book that stuck with me is where Andrew tells the story of taking his son to the National Zoo in Washington DC, who was then a toddler. “As expected, my son was delighted with the Great Ape House, but for me, this visit was nothing less than transformational.”

Lo describes his family standing in front of a group of orangutans, where the alpha male of the group came surprisingly close to the iron-bar fencing separating the great apes from the visitors. In response, Andrew pulled his son away from the fence to keep him out of danger. This startled the alpha male’s companion, who instantly moved in front of the younger orangutan to repel Andrew’s advance- in essence mirroring each other’s behaviour.

The human brain works in mysterious ways. At that precise moment, I saw clearly how the Efficient Markets Hypothesis and its behavioural critique could be reconciled. In fact I understood two things that should have been obvious to me all along, but which I had never thought about until then.

The first insight Andrew had was just how instinctive our primate behaviour is and the the legacy of our shared ancestry, where 97% of our DNA is identical to that of chimpanzees. However Andrew notes the large gulf between our species, where one of these primates carried on their life as usual held in captivity, where the other would go on to write a book detailing the experience and resolving a longstanding academic controversy. Lo argues it is this 3% of the human genome that separates us from other primates, which enables cultural innovation and human ingenuity, and permits advanced economic activity and efficient trading.

The core argument presented in Adaptive Markets is that financial markets do not follow the laws of economic theory. Rather, financial markets are the product of human evolution, and follow the laws of biology instead.

Undoubtedly, behavioural economists have helped improve our understanding of economic decision-making. However, what behavioural economists neglected to answer is the ultimate question: why do people possess these psychological dispositions? Answering ultimate questions leads one to evolution, as the human brain has been honed by the forces of natural selection.

As stated by Lo:

Economic behavior is one aspect of human behavior, and human behavior is the product of biological evolution across eons of different environments. Competition, mutation, innovation, and especially natural selection are the building blocks of evolution. All individuals are vying for survival- even if the laws of the jungle are less vicious on the African Savannah than on Wall Street. It’s no surprise, then, that economic behavior is often best viewed through the lens of biology.

A key concept Lo uses to explain economic behaviour is an evolutionary mismatch:  traits selected for in our ancestral past which were once advantageous, which become maladaptive when the environment changes. For example, Lo argues evolution can help explain loss aversion and people’s inclination to ‘probability match’ in financial settings, which can result in sub-optimal investing.

Financial behavior that may seem irrational now is really behavior that hasn’t had sufficient time to adapt to modern contexts. An obvious example from nature is the great white shark, a near- perfect predator that moves through the water with fearsome grace and efficiency, thanks to 400 million years of adaptation. But take that shark out of the water and drop it onto a sandy beach, and its flailing undulations will look silly and irrational. It’s perfectly adapted to the depths of the ocean, not to dry land.

For the past 50 years, academic finance has been dominated by highly mathematical models and methods that derived from physics. These sophisticated quantitative techniques spawned a wave of financial innovation, and triggered an evolutionary change within the world of finance. However, Lo argues that despite the advantages these advanced quantitative techniques provided, this mass ‘mathematization’ of finance has significant flaws.

Finance isn’t physics, despite the similarities between the physics of heat conduction and the mathematics of derivative securities, for example. The difference is human behavior and the role of evolution in its development… The financial crisis showed us that investors, portfolio managers, and regulators do have feelings, even if those feelings were mostly disappointment and regret during the last few years. Financial economics is much harder than physics.

The Financial Crisis

Much of Adaptive Markets is dedicated to the 2008 financial crisis. Although there are numerous causes of the crisis, Lo argues that at the most fundamental level the primary cause of the crash was greed overpowering fear.

The Adaptive Markets Hypothesis tells us that, at the most basic level of the financial crisis, greed overwhelmed fear. Ignoring the changing environment, people at all levels of the system created a narrative that greed was good. The pushback against the warnings about the oncoming crisis was stronger than the warnings themselves- until it was too late. 

Rather soberingly, Lo details how economists such and Robert Shiller and Raghuram Rajan raised the alarm of the American housing market showing signs of a bubble, which could potentially lead to a catastrophic meltdown of the financial system. However, these concerns were largely ignored by the wider financial community. With the benefit of hindsight, such warnings were remarkably prescient.

Lo’s own research on the hedge fund industry also showed early warning signs of the financial crisis. Back in 2005, journalist Mark Gimein published an overview of Lo’s research in the New York Times. The last paragraph reads; “The nightmare script for Mr. Lo wold be a series of collapses of highly leveraged hedge funds that bring down major banks or brokerage firms that lend to them”.

Apparently Lo’s warning seemed ridiculous at the time, yet in hindsight various hedge funds collapsed at the start of the crisis “and the fact that Bear Stearns and Lehman Brothers both experienced their first wave of losses through their hedge funds, it wasn’t too far off the mark.”

Hedge funds are described by Lo as the ‘Galapagos Islands of finance’, being a novel species of finance that exploit market anomolies which are highly vulnerable to changing environments. According to Lo, increased complexity combined with tighter coupling and a new spawn of financial gigantism increased the odds of a catastrophic meltdown.

Lo also takes the opportunity to challenge the narratives we share to explain the financial crisis. For example, one common theme is that the financial crisis was the result of the unscrupulous practices of financial elites. Although there is much truth to this story, Lo argues many determinants of the crisis were systemic and were not caused by ethical lapses. However, this claim is contested by leaders in the field.

Finance Behaving Badly

Not only does Adaptive Markets cover the basics of evolutionary psychology, it also makes reference to the cultural evolution. Lo makes clear that culture, a domain which is frequently deemed beyond the realm of biology, is itself the product of evolution. That is, subject to the processes of variation, selection and replication. A core argument in Adaptive Markets is that an evolutionary perspective of culture can help us identity and prevent financial scandals.

Long before the days Gordon Gekko became a cultural icon, social psychologists have studied what leads ordinary people to behave like monsters. The infamous Milgram and Zimbardo Stanford prison experiments were conducted during the 1960s and 1970s respectively, and demonstrated in shocking and graphic detail how blind obedience to authority can lead ordinary people to commit atrocities.

Lo notes how little people were paid to participate in these experiments, and yet still were complicit in such unthinkable acts. Milgram paid his participants roughly today’s equivalent of $36, where Zimbardo paid his subjects roughly $90 in today’s money.

Imagine a situation in which you were instructed to engage in questionable financial practices- actions that aren’t nearly as gut-wrenching as delivering electrical shocks- by a managing director or vice president in a suit and tie, and you’re given tremendous financial incentives, like a multi-million dollar year-end bonus, to do so. In light of the Lucifer Effect, it’s not hard to understand how context and culture can lead to even caring and ethical individuals to do reprehensible things to unsuspecting clients. This is the Gekko Effect. 

One possible critique of Adaptive Markets is that it emphases the importance of the environment, yet it does not adequately address the environmental forces shaping financial institutions. However, Lo’s reflections on regulation and corporate fraud is a clear exception.

Although the data is confined to the United States and the time series is rather small (especially when considering evolutionary time-scales), Lo provides evidence that financial scandals and scams are cyclical. That is, historically financial scandals have increased as stock markets rose, and declined once market conditions deteriorated.


Lo Dyck, Morse and Zingale's (2013, figure 1) estimates of the percentage of large corporations starting and engaging in fraud

Estimates of the percentage of large corporations starting or engaging in fraud, from 1996-2004 (Dyck, Mores & Zingales, 2013)

Deason et al (2015) Frequency of SEC- prosecuted Ponzi schemes by calendar quarter from 1988 to 2012

Frequency of SEC prosecuted Ponzi schemes by calendar quarter from 1988 to 2012 (Deason, Rajgopal & Waymire, 2015)

These findings may seem counter-intuitive. However, the researchers investigating ponzi schemes make it clear that such large-scale fraud is harder to sustain during deteriorating market conditions, as was the case with Madoff. Lo also notes that regulatory budgets increase after financial bubbles burst.

Lo states the unravelling of Madoff also revealed the biases and blind spots of financial regulators. Although social scientists have much to learn about the behaviour of auditors and financial regulators in the lead up to such scandals, Lo argues loss aversion may help explain why regulators don’t react quicker to signs of disturbance. That is, being more concerned about being wrong and causing a public scandal than investigating cases of potential large-scale fraud.

Fixing Finance 

Lo argues that if we wish to change financial culture and tackle corporate malfeasance, we first have to understand the broader contextual and environmental forces that have shaped such cultures over time and across circumstances.

As a professional working in the field, I’ve observed increasing activity to monitor aspects of organisational culture within the banking industry. However, I believe we’re only beginning to grapple with this challenge, and that various issues need to be addressed. To elaborate, what do we mean exactly when we refer to ‘culture’, how do we measure it, and which aspects of culture can actually be changed and should be prioritised?

Lo provides some excellent advise here, and demonstrates the importance of framing.

The first step requires a subtle but important shift in our language. Instead of seeking to “change culture”, which seems naive and hopelessly ambitious, suppose our objective is to engage in “behavioural risk management” instead… Despite the fact we’re referring to essentially the same goal, the latter phrase is more concrete, feasible, and- this is important- unassailable from a corporate board’s perspective.

To conclude, a core theme of Adaptive Markets is that the financial system is more similar to an ecosystem of living organisms than a machine, and that we must manage the system accordingly. This is a very different perspective compared to traditional approaches of financial regulation, however Lo notes the list of prominent economists who have reached similar conclusions.

Despite certain reviews of the book arguing that the Adaptive Markets Hypothesis offers little practical value, this theoretical insight arguably has many practical implications.

For one, it shows investors how markets are not wholly efficient and can be beaten, and makes clear that specific investment strategies can either succeed or fail depending on the broader financial environment.

Lo shares some big ideas on how large-scale investment funds can be designed to address pressing social problems, such as the high cost of developing new cancer drugs.

For regulators, the adaptive toolkit provides ways of addressing the cultural roots of corporate maleficence, which could help prevent the next Bernie Madoff from succeeding.

Written by Max Beilby for Darwinian Business

Click here to buy a copy of Adaptive Markets

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