When it comes to Behavioural Finance, a few people stand out in terms of their contribution to helping us all understand why and how it works. The intersection between Human Behaviour and Quantitative Investing can be difficult to understand for even the most sophisticated investors. Today, I want to share some really important insights from one of my favorite professors, who is also a practitioner of this discipline, namely Andrew Lo of MIT Sloan School of Management and Director of MITs laboratory of Financial Engineering. Many people know Andrew as the father of the Adaptive Market Hypothesis, and our conversation was wide ranging, entertaining, and deeply insightful. So enjoy these truly unique take aways from Professor Andrew Lo, and if you would like to listen to the conversation in full, just go to Top Traders Round Table Episode 18 and Episode 19.
The Ecosystem of the Financial Markets
Niels: Now, our conversation today will focus on a number of different topics within the managed futures industry, and, perhaps, a few that will fall a little bit outside of this. So, to kick things off in a slightly different way, I want to come to you, Andrew, first, and ask what you think of when I say Rabbi Mahony, Rabbi Mahony, Rabbi Mahony, and I hope you know what I’m referring to so that our listeners don’t think that I’ve completely lost it at this stage.
Andrew: Well, thank you for bringing that up. That comes from one of my stories that I’ve written about in my book, Adaptive Markets. It’s an idea about thinking about financial markets more like a biological ecosystem rather than a physical system. As you may know, most economists suffer from this disease that I call physics envy. We wish that we had three laws that explained ninety-nine percent of all behavior, the way the physicists do. In fact, we have ninety-nine laws that explain only three percent.
So, the idea behind adaptive markets is that we really have to think about these financial market dynamics as coming from human interactions, and trying to model those human interactions is really critical. So, the Rabbi Mahony story really has to do with the fact that I heard many years ago about a technique for getting parking in Harvard Square. It’s a terrible, terrible challenge to drive a car into Harvard Square because there is never any parking. So, for years I just decided not to do it. But, a friend of mine said that, if you used this following algorithm: before you go to Harvard Square you utter the incantation, Rabbi Mahony, Rabbi Mahony, Rabbi Mahony, at that point you should be able to go to Harvard Square and get parking.
The amazing thing is this algorithm actually works. But, the more interesting reason is why it works. It works because it changes the way we behave. It changes our expectation for getting a space. Because now, once you utter the incantation, you must, somehow, in a part of your brain, believe that you might be able to get a space and that changes the way you drive. It changes how you look for parking, and, magically you actually increase the chances of getting a space. So, it really says that human behavior can actually change our reality. Sometimes things need to be believed in to be seen.
Niels: Yeah, absolutely. Just out of curiosity, do you think that belief always precedes action and plausibility?
Andrew: I think it is something that happens simultaneously, in many cases. Our beliefs have an impact on our behavior, but our behavior has an impact on reality, and that reality shapes our beliefs. So, it’s kind of a feedback loop that is happening and updating all the time. Unless we’re aware of that, it’s very easy for us to get mislead by various kinds of market events and ultimately end up down a rabbit hole of behavioral biases that ultimately end up hurting us in our investment strategies.
Niels: Yeah, well I look forward to finding out whether this little chant also works finding a parking place here in Switzerland.
Andrew: You should try it.
'Part of the reason why the volatility of volatility is high is because we now see geopolitical events playing a much more important role in financial markets, really ever since the Financial Crisis.'
Niels: I’ve heard you talk about the importance of language and the environment when it comes to creating new behaviors. I think we can all agree that the environment, in the financial markets, has changed dramatically in the past few years. Here, particularly thinking of the level of volatility we’ve seen in markets, and perhaps, first and foremost, the lack of volatility in the U.S. stock markets, at least until quite recently, so share with us why is it so important, and what are the risks that you see from a change in market environment like that?
Andrew: Well, in fact, you bring up a very important point. The volatility of financial markets has become much less predictable than before. So, you’re right that volatility is quite low relative to historic levels. But I would argue that the volatility of volatility is actually quite high. That really suggests that we need to look at another dimension of risk, and that is something that very few of us are prepared to do. Part of the reason why volatility of volatility is high is because we now see geopolitical events playing a much more important role in financial markets, really ever since the financial crisis. Prior to the crisis, it was rare that you got major central banks involved in the kinds of interventions that we see today. But, since the financial crisis, it has actually become expected for central banks and governments to start intervening in financial markets directly.
So, you now have very large players that feel no hesitation to engage in the kinds of activities that have a direct impact on market dynamics and, therefore, volatility can be actually affected to a great degree. It’s just over the last few months, in terms of current events, when there are concerns about trade wars or threats with various different geopolitical entities because of disagreements and concerns regarding policy. All of those issues, now, factor into markets in a much more direct way than over the previous ten years
Niels: I completely agree with both of you about this alpha, beta, and so on and so forth. But in terms of bigger themes, I’m just curious. Have any of you started seeing what the next big narrative could be going forward so to speak? Are there any new things on the horizon that might become the next big talking point?
Andrew: Well, you know someone once said that history may not repeat itself, but it sure does rhyme. I actually think that there’s a lot of rhyming going on right now. In other words, I do think that we live in a unique economic environment and so there are things going on today that really didn’t exist ten or fifteen years ago. But, the mechanisms by which those various different, unique challenges have emerged, they have very much the same impact on financial markets. So, one example is this notion of a trade war. We’ve actually enjoyed a rather long period, prior to the most recent time, where we’ve engaged in open trade with various partners around the world. One of the reasons that mega economies like China and India have emerged as real forces in the twentieth and now the twenty-first century is because of international trade. So, this idea of a trade war, that’s actually pretty new. Obviously, there have been trade wars many, many times in the history of the world.
But the difference is today, because of the nature of the way we interact with various different economies. The fact that we’re engaged in trade at the speed of light, if you will, because of the internet and all the kinds of connectivity we enjoy across these various trading regions. The threat of a trade war, the mere threat of a trade war is enough to actually cause businesses to pull back and to change the way that they invest in their infrastructure.
So, we now have technology enabling all of these various businesses to react much more quickly. I think that’s what we need to worry about. That’s the new kind of perspective on how these old themes are emerging.
Andrew, again, because 2018, for many investors, was a year where they came back and said, “Well, where was that negative correlation you talked about?" when looking at managed futures returns during the event of January, February of 2018, and then we had another kind of event in October of 2018. So,
I know Katy Kaminski just recently wrote a paper about correction versus crisis, so, since I have both of you here today, I would love to hear you explain the subtle difference between these two things that actually makes performance in 2018 a little bit more understandable for investors who were seeking or allocating to managed futures and trend followers in order to get some benefit through the year of 2018, but of course, they didn’t get it for the most part. So, can you explain a little bit about… and maybe start with you again Andrew, just a little bit about how you see the difference between the crisis, where maybe crisis alpha can play a role, but also the times where it just turns out to be “a correction,” and it doesn’t really help out?
Andrew: Sure, well, the idea behind managed futures is that they adapt to these changing trends and, in order for you to be able to identify a trend you obviously need a period of time where markets are going in a particular direction. When markets are going left and right, and left and right, when they become very choppy, that’s an environment where trend following is going to underperform. That’s, I think, a very different environment than the kind of crisis alpha that Katy and others have written about.
'Emotional reaction is going to be very difficult to model, unless we have really deep data about how sentiment is propagating throughout the market place.'
So, this past year, I would argue, has been much more a set of choppy markets where traditional managed futures is going to have difficulty. But, there are other investments that ultimately would need to come to bear to provide that kind of return for investors in these markets. But, this is part of the problem of political instability. In a period of great political uncertainty, investors are going to have a hard time generating returns because the way that we generate returns, the way that all investors are able to generate returns is to put money to work in a productive way. So, whether it’s investing in technology or biomedicine, or infrastructure, the way that any of us will earn a return for our investors is to be able to allocate capital to productive goods and services.
In an environment where there’s general political uncertainty, people are going to want to keep their powder dry. It’s like going into a Las Vegas casino. If you’re a card counter, and they don’t catch you, because we know that card counting is not permitted in these casinos, but if you go into a casino and you’re a card counter, and you have expertise, you have an edge, you will definitely be able to earn a better rate of return than a typical gambler who is just going there for fun.
So, these professional poker players are clearly going to earn a higher rate of return. But, imagine going into a casino where you sit at a table, and the dealer says, “Well, we’re going to play a game, but I’m not going to really tell you what the game is. Moreover, whatever you think the rules are? Along the way, I get to change the rules without telling you when I’m going to do that, and why I’m going to do that. How many professional poker players do you think will want to play in that kind of a setting? My guess is very few.
I think this is an example of fear and greed overwhelming rational deliberation. I think investors are spooked and it’s going to be a very difficult market in which I’d be able to identify these kinds of trends until such time as investors start thinking a little bit more rationally. Not to say that emotional reaction is not a reasonable thing to experience but it is something that is going to be very difficult to model unless we actually have really deep data about how sentiment is propagating throughout the market place. There may be some hedge funds out there that are monitoring social media and are able to make those kinds of predictions. But, it is something that is going to make market dynamics much more complex over the course of the next few months and perhaps even years.