The Adaptive Markets Hypothesis: A Step In The Right Direction

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.

Core Beliefs and Principles of the Traditional Investment Paradigm

Principle 1:  The Risk/Reward Trade-Off.  There’s a positive association between risk and reward among all financial investments.  Assets with higher reward also have higher risk.

Principle 2:  Alpha, Beta, and the CAPM.  The expected return of an investment is linearly related to its risk (in other words, plotting risk versus expected return on a graph should show a straight line), and is governed by an economic model known as the Capital Asset Pricing Model, or CAPM.

Principle 3:  Portfolio Optimization and Passive Investing.  Using statistical estimates derived from Principle 2 and the CAPM, portfolio managers can construct diversified long-only portfolios of financial assets that offer investors attractive risk-adjusted rates of return at low cost.

Principle 4:  Asset Allocation.  Choosing how much to invest in broad asset classes is more important than picking individual securities, so that asset allocation decision is sufficient for managing risk of an investor’s savings.

Principle 5:  Stocks for the Long Run.  Investors should hold mostly equities for the long run.

The almost universal acceptance of these principles may actually have the opposite effect: lessening returns over time.  Take Principle 4, which emphasizes asset classes over individual securities.  This completely removes the investor’s connection of her investment to the very real operating business she owns, or the actual entity she is lending money to. By default, this could encourage speculation based more on fear and greed than on the fundamental relationship between price and value. 

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Disclosure: Anderson Griggs & Company, Inc., doing business as Anderson Griggs Investments, is a registered investment adviser.  Anderson Griggs only conducts business in states and ...

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