The Origin of Species
Aug 21st, 2008 | Filed under: CAPM / Alpha Theory, Today's Post
Melvyn Teo’s paper on the relative merits of locally-based Asian hedge funds vs. those with no local presence (see yesterday’s posting) amounts to a significant indictment the Efficient Markets Hypothesis. After all, why would one group of managers (i.e., those without a local office) be willing to forgo higher returns? And why wouldn’t investors just stop investing in sub-optimizing, apparently irrational funds? It’s as if these two groups were totally different species or something.
And indeed, they may be different species - in a sense. Back in 2004, MIT’s Andrew Lo, the author of a huge library of refreshingly easy-to-read papers and articles, proposed a successor to the EMH that actually defined different groups of investors (pensions, individuals, traders etc.) as different “species” of investors and expanding on the biological analogy. His resulting Adaptive Markets Hypothesis (AMH) explains the apparent irrationality of markets as a rational reaction to a change in environmental conditions. His Journal of Portfolio Management paper can be downloaded here (academic version available here).
Drawing from behavioural finance, Lo says that investors make decisions using heuristics drawn from trial and error, not from concrete analytical models. Drawing a page from Darwin, he says that without adequate trials and errors, there is no adaptation.
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