[Namsan Ddalggakbari] The Financial Market Is Alive and Therefore Evolves

Andrew Lo MIT Professor's Book 'Evolutionary Theory Goes to Financial Markets'... "Our Goal Should Be to Influence Finance"

[Asia Economy Reporter Ryu Jeong-min] "The financial system is a kind of ecosystem that struggles for survival."

The perspective of Andrew Lo, a professor at the Sloan School of Management at the Massachusetts Institute of Technology (MIT) in Cambridge, Massachusetts, is unique. This is because he interprets the financial market from a completely different viewpoint than the mainstream theory known as the 'efficient market hypothesis.'

It is an interesting approach that unravels the secrets of the financial market based on evolutionary theory. Does the financial market truly possess the characteristics of a living organism that competes for survival, continuously reproduces, and adapts to its environment? Evolutionary Theory Goes to the Financial Market is a book that answers this curiosity. Experts' attention has been drawn to this paradigm shift surrounding the financial market.

It is no coincidence that Evolutionary Theory Goes to the Financial Market was selected as the Best Economics & Business Book by the American Publishers Association, the Best Book by Bloomberg, the Best Social Science Book by the American Publishers Association, and a Business Leader's Book by The Wall Street Journal (WSJ). Why did experts highly appreciate Professor Lo's attempt to break away from conventional thinking?

On the 28th, KOSPI opened at 2,192.22, down 53.92 points (2.4%) from the previous trading day due to the spread of fear over the novel coronavirus infection known as 'Wuhan pneumonia.' Dealers are seen working in the dealing room of KEB Hana Bank in Jung-gu, Seoul. On the same day, the won-dollar exchange rate started trading at 1,178.5 won, up 9.8 won from the previous trading day. Photo by Kang Jin-hyung aymsdream@

The adaptive market hypothesis assumes that a biological way of thinking is much more useful in understanding changes in the financial industry. The foundation of the adaptive market hypothesis is the view that market prices can deviate from rational levels due to emotional responses such as fear and greed. This book contains extensive knowledge from various fields including psychology, evolutionary biology, neuroscience, and artificial intelligence (AI) across its 550 pages.

"The adaptive market hypothesis includes both human irrationality and rationality and shows that two types of behavior can coexist in the process of evolution through natural selection." What does Professor Lo's claim mean?

Economists regard the phrase "there is no free lunch" as a golden rule. It means that without taking a certain level of risk, one cannot obtain returns. The degree of individual risk aversion varies. There are conservative investors who only invest in government bonds, and hedge fund managers who bet trillions of won on a single stock.

Professor Lo explained, "In the efficient market hypothesis, consumers make mathematically optimal consumption based on rationality, whereas in the adaptive market hypothesis, consumers' choices reflect the history of past evolution."

The core of the adaptive market hypothesis is that individual rationality operates only within a limited scope. Professor Lo argued, "Economists have applied highly mathematical theories based on rational behavior to every imaginable domain, but biology is much more useful than mathematical physics theories in explaining the limited rationality of human behavior."

The adaptive market hypothesis is one of the alternatives that can replace the efficient market hypothesis. Considering the theoretical development process, it is still in its early stages and requires further research. However, it is important to note that it plays a role in solving problems that are difficult to interpret from the mainstream perspective.

In this regard, Professor Lo's diagnosis of the 2008 financial crisis is intriguing. There is a diagnosis that excessive incentive payments on Wall Street caused the financial crisis. However, his view is that there is a lack of objective evidence. It is merely a conclusion that the public wants to believe, far from the essence.

"From the perspective of the adaptive market hypothesis, the fundamental cause of the financial crisis was greed that overwhelmed fear. ... Almost everyone participating in the market activated the 'nucleus accumbens,' which captivates greed, more than the 'amygdala,' which causes fear (in the brain)."

This means that the 2008 financial crisis cannot be seen solely as a problem of a specific group that shook the economic system. Professor Lo pointed out, "Who benefited in the era of excess? The answer is everyone. Financial institutions, politicians, builders, the media, and almost all Americans benefited from the housing bubble. Everyone wanted this bubble to continue."

He explained that as nearly two decades of stable conditions without severe recessions continued, people began to underestimate latent risks. According to Professor Lo, this is not due to human foolishness but a process of adapting to environmental changes.

Then, was there no way to prevent the 2008 financial crisis? Professor Lo urged, "We must always pay attention to new changes occurring within the system," and "Regulatory authorities themselves must identify potential problems before they become serious."

Professor Lo's unique diagnosis aligns with an unexpected rosy blueprint. He claims that a financial market based on the adaptive market hypothesis can solve humanity's concerns such as cancer, poverty, and energy within 20 years.

"If you invest in 150 new drug development projects, the average cost per project is $200 million, requiring a total of $30 billion. The probability of at least three successes among the 150 projects is 98%. ... Success in one new drug development creates an average value of $12.3 billion. With a 98% probability, you will hold about $37 billion ($12.3 billion × 3) in 10 years."

If financial products related to new drug development could be created based on such a scenario, it would be possible to solve intractable diseases like cancer and expect enormous profits. Finance, depending on our mindset, can play the role of a savior for humanity rather than a zero-sum game.

Professor Lo concluded the book with the following message: "If we do not consider investment returns, we cannot raise sufficient funds to solve the severe problems facing humanity. We should not let finance dictate our goals; rather, our goals should dictate finance."

This content was produced with the assistance of AI translation services.