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.