Last week I was invited to an M.I.T. Sloan session featuring Andrew Lo, the renowned academic who has developed over the years unique and celebrated insights about the functioning of the world and its implications for the economy and financial markets.
When sharing his perspective about the current health crisis (presentation attached), Mr. Lo splits the future into three horizons. In the short run (defined as the next 3-6 months), he sees no alternative to an increase in the volatility of the volatility driven by policy uncertainty, with a return to social distancing enforcement and mobility restrictions causing the economic and psychological toll to mount. Expectations ought to be set accordingly - there is just no way around it.
In the mid run (6-24 months), however, treatments, testing and immunity lead to a gradual relaxation of the restrictions in place with stock markets rising further in anticipation. Beyond that, as the world moves deeper into the 20s, a period of tremendous growth ensues.
According to Mr. Lo, this sanguine outlook is supported by the concept of ‘adaptive radiation’ associated with an acceleration in the adoption of new technologies. The terms refer to ‘the evolution of ecological diversity within a rapidly multiplying lineage, [whereby] a single lineage evolves to become a series of slightly modified versions of its ancestor.’ The most commonly cited example is Darwin’s finches: more than a dozen of species of finches found on the Galapagos archipelago are proven to be descending from one ancestral species. The beaks of Galapagos finches adapted to different types of food supply through an evolutionary process as the birds sought to exploit an ecological opportunity.
In his book ‘Adaptive Markets’ (2017), Mr. Lo takes hedge funds as an example of adaptive radiation (see here): These firms implement dynamic investment strategies and tend to adapt the fastest to any given environment, which gives them a chance to generate abnormal returns. But this hyper-adaptation requirement comes with challenges, which is why new species of hedge funds emerge and old ones die all the time.
Consistent with his biological approach, Mr. Lo argues that a suboptimal economic behavior should be described as ‘maladaptive’ as opposed to ‘irrational’ since the firm or individual in question is deemed to act rationally but under an erroneous assessment of its environment. By extension, if the financial markets are inefficient, it is not because some investors act irrationally, Mr. Lo posits, but because they have failed to adjust to a new set of circumstances.
There is much to like about the Adaptive Market Hypothesis, starting with the idea that a perfectly rational behavior can lead to various behavioral outcomes. Perhaps my only remark is that making the right decisions does not rely upon a reactive, natural, biological response, but upon an active, deliberate, intellectual act. In that respect, individuals and leadership teams, unlike finches, are inescapably responsible for their own future.