I am a sucker for kids from middle-class Queens who become great successes. (I am one, without the success part.) Andrew Lo, a M.I.T. finance professor and hedge fund manager is one of the more notable ones. Aside from being a finance super-star, Andrew Lo is a great story teller. I wish I could take his class. However at times he tells too much and as result his 504 page book in the print edition is too long.
Lo’s thesis, building on the work of Kahneman, Tversky, Thaler and Haidt argues rather convincingly that the home economicus model that modern day financial economics relies on is a special case and shouldn’t be generalized for all markets in all seasons. Thus the physics math that finance uses, while it creates reasonably good heuristics, is not complete. Simply put the efficient market hypothesis works most of the time, but not all of time.
Lo is an expert on modern finance and he presents a well-documented history as to how it came into being starting with an obscure mathematics dissertation written in French by Louis Bachelier which ultimately became the foundation for options pricing models. He makes one mistake here by noting that Paul Samuelson received his Ph.D. in 1947. It was 1941 while his Ph.D. was formally published in 1947.
Be that as it may Lo brings to the table of modern finance neuroscience, evolutionary biology and behavioral economics. When doing this much of the rigor of physics math goes away but it makes his adaptive markets far more relevant to the real world. After all, despite the rise of the machines, markets are made by human beings who have a multitude of motives many of which are not “rational” and many of which are unconscious. Instead of thinking about the day-to-day chaos that appears on the stock exchanges, think of traders fighting for survival on the African Savannah. This would certainly put the concept of seeking alpha in a different light.
Professor Lo also comes up with a neat idea for mass funding of cancer research through the creation of a $30 billion biotech fund that is following the science rather than the near term dictates of the venture capital market place.
In sum, Andrew Lo has written an important book and it should be part of the curriculum in all serious finance departments.
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