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Wednesday, April 19, 2006

Survival of the Richest

Why are some people better adapted for making money in the financial markets? Sloan School's Andrew W. Lo explains.

By Michael Fitzgerald

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Financial markets are supposed to pool the knowledge of market participants to come to the most efficient decision about matters like what a stock is worth. They're supposed to be rational -- driven by the numbers and facts. But, in fact, financial markets are better understood as biological systems, argues Andrew W. Lo, professor at MIT's Sloan School of Management and director of the MIT Laboratory for Financial Engineering.

Lo, also a partner in the AlphaSimplex hedge fund, combines mathematics, neurology, and psychology to study how markets work. One of his research projects actually involves putting traders in an magnetic resonance imaging (MRI) machine and measuring their brain activity. Once a disciple of the Efficient Markets Hypothesis -- the premise that markets operate rationally and efficiently -- Lo wants to replace that model with the biologically driven Adaptive Markets Hypothesis.

Technology Review: When did you decide that biology might help you to understand how markets behave?

Andrew W. Lo: I've always been interested in biology, and evolution is one of most important topics in modern science and society. So little by little I tried to think about how it is that evolution affects economic interactions. I remember about ten years ago, where at the end of the year I felt so frustrated that [the Efficient Market Hypothesis] didn't make sense to me. And then the year after, when I started really taking more seriously the notion of evolution and its impact on financial markets, it somehow all fell into place. It's such a simple idea: namely, that financial market participants adapt to changing market conditions. That seemed to explain pretty much everything. In the last five or six years I've used this paradigm to explain one anomaly after another. And at this point I really feel like there isn't a single anomaly that financial market participants have documented that I cannot explain with this framework.

TR: Can you give us an example of evolution working in financial markets?

AL: An example of behavioral bias is what psychologists like to call "loss aversion." When you're faced with losses you become much more risk-seeking; and when you're faced with large gains, you become much more conservative, much more risk-averse. And that, people have documented, is generally not conducive to building wealth. It's rational to cut your losses and ride your gains. Instead, in practice what people do when they're losing is to double their bets in the hopes of getting back to even -- traders call it doubling down. And when you're making money you cash out right away and preserve your gains. That is irrational behavior in financial markets.

I've derived a simple mathematical model to show that loss aversion is really the outcome of a survival instinct. This notion of loss aversion, being more aggressive when you're losing and more conservative when you're winning, is a very, very smart thing to do when you're being hunted on the plains of the African savannah. However, it's not a smart thing to do when you're on the floor of the New York Stock Exchange.

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Comments

  • Pitch
    Guest (Don Moore) on 04/19/2006 at 12:00 AM
    Posts:
    1
    Am I the only one that thinks this sounds like a late night tv sales pitch?
    Rate this comment: 12345
  • Survival of the Richest
    Guest (Chuck Thompson) on 04/19/2006 at 12:00 AM
    Posts:
    1
    Professor Lo should check out the betting patterns of good gamblers.  For instance, a common technique of craps players is to bet progressive units which involves betting larger unit bets when you are winning and fewer when things cool down.  Purely subjective, but produces better results than betting the same unit bet all the time according to my casual observations.
    Rate this comment: 12345
    • Survival of the Richest
      Guest (Al Rosen) on 04/19/2006 at 12:00 AM
      Posts:
      1
      "Why Most Things Fail" by Paul Ormerod similarly expands the Theory of Evolution into disciplines other that biology, in particular business organizations. Should I continue to expect winning results from B-school educated financial "managers"?
      Rate this comment: 12345
      • survival of the richest
        Guest (daphne cash) on 04/23/2006 at 12:00 AM
        Posts:
        1
        i think there are many undiscovered corollaries between our hard wired biological responses which were developed and evolved from a totally and completely direct way of human interaction with the natural planet and how those hard wirings function or do not function in the constructed world which we now occupy, for all intents and purposes. as it is true that certain types of personalities are better at certain kinds of tasks, so those personalities reside in differing types of body structures. so it would only make the clearest sense that our evolution and our resultant bodily abilities to adapt to the synthetic structures of modern life are and furtherance of our evolutionayr function.

        makes perfect sense to me.
        Rate this comment: 12345
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