Monday, December 11, 2017

Biology, not Physics

I've mentioned the Odd Lots podcast before. It is very smart, and a lot of fun. The hosts are Bloomberg's Joe Wiesenthal and Tracy Alloway.

A recent episode is one of their best. In it, Andrew Lo, of MIT, describes financial markets as a mix of  both the neat efficiency described by neoclassical economics, and the messy emotion and misjudgment described by behavioral economics. Most of the time, market are fairly efficient, but on occasion, emotion takes over and fear or greed become dominant. That may seem like common sense, but I have not heard these two opposing views squared so well before.

One particular point Lo makes is that biology or ecology makes a better model for markets than physics. In ecology, there are things to count and measure, like the number of animals in a species and their weight, but there are also facts that are soft, and not readily modeled in equations. What does a species of animal feed on? What preys on it?

Switching back to investing, the advent of ETFs has increased the popularity of index investing, and this needs to be thought of ecologically. The growth in ETFs will hit its limit, as a proportion of the total, at some point. If you look only at price/earnings ratios, for example, it is hard to understand why the stock market has moved as it has. You have to look at the institutional structure of a market, too, which changes over time. Who are the players, at any given point? What are their constraints?

In other words, financial markets are complex adaptive systems, Lo says. They cannot be modeled fully, and are prone to breaking down. William White has said the same.

Anyway, I recommend this episode. I get it on my phone's podcast app, but you can also listen on the web via the first two links above. If you get into it, you will also like the recent Odd Lots episode with Citigroup's Matt King. King describes quantitative easing in a way that is entirely consistent with how Lo sees things.