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Adaptive Markets
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Table of Contents

Introduction 1 Financial Fear Factor 1 Don't Try This At Home 4 The Great Divide 6 "It's the environment, stupid!" 8 Revenge of the Nerds 10 1 Are We All Homo economicus Now? 12 Tragedy and the Wisdom of Crowds 12 A Random Walk through History 16 The Birth of Efficient Markets 20 Efficient Markets Unpacked 25 What to Expect When You're Expecting 28 Efficient Markets in Action 38 2 If You're So Smart, Why Aren't You Rich? 45 Rejecting the Random Walk 45 Risk versus Uncertainty and the Ellsberg Paradox 51 Losing Hurts More than Winning Feels Good 56 No-Limit Texas Hold 'em, Rogue Traders, and Regulators 59 Probability Matching and March Madness 62 Humans as Prediction Machines 65 It Takes a Theory to Beat a Theory 69 Culture Shock 71 3 If You're So Rich, Why Aren't You Smart? 75 Looking under the Hood 75 The Microscope of Neuroscience 76 Fear 78 Pain 85 Pleasure and Greed 87 Wired-Up Traders 92 The Stuff Good Traders Are Made Of 94 Mind over Money via Neural Currency 96 I Want It All, and I Want It Now 98 4 The Power of Narrative 102 A New Meaning of Rationality 102 The Human Fire Alarm and Sprinkler System 104 The Fear Factor and Finance 106 I Know You Know That I Know 108 Homo economicus and the Left Hemisphere 113 The Prefrontal Cortex as CEO 117 The Power of Self-Fulfilling Prophecies 123 Barbara Ficalora, the Best Third Grade Teacher Ever 124 Narrative Is Intelligence 128 5 The Evolution Revolution 135 A Day at the Zoo 135 The Evolution Revolution 136 Just-So Stories or Scientific Fact? 138 The Power of Selection 141 Variety Is the Spice of Life 144 "It's the environment, stupid!" 146 The Emergence of Homo sapiens 150 Enter Homo economicus 152 An Evolutionary Pecking Order 156 Swedish Twins and Savings 158 Evolution at the Speed of Thought 162 Sociobiology and Evolutionary Psychology 168 Survival of the Richest? 175 6 The Adaptive Markets Hypothesis 176 It Takes a Theory to Beat a Theory 176 Simon Says Satisfice 177 The Superman Jacket 182 The Adaptive Markets Hypothesis 185 Probability Matching Explained 189 Nature Abhors an Undiversified Bet 195 "It's the environment, stupid!" All Over Again 196 Homo economicus and Idiosyncratic Risk 198 The Origin of Risk Aversion 203 Efficient versus Adaptive Markets 206 Waylaid by Physics Envy 208 On the Shoulders of Giants 214 7 The Galapagos Islands of Finance 222 Quantum Mechanics 222 Mission Impossible 224 The Islands of Evolution 225 Hedge Fund Archipelago 227 An Evolutionary History of the Hedge Fund 231 The Birth of Quants 235 The Revenge of the Nerds 236 Quant Goes Mainstream 240 The Evolution of the Random Walk 244 Cell Phones and Kerala Fishermen 246 8 Adaptive Markets in Action 249 The Traditional Investment Paradigm 249 The Great Modulation 254 A New World Order 256 Risk/Reward and Punishment 258 The Democratization of Investing 263 New Species of Index Funds 265 Smart Beta versus Dumb Sigma 267 Disbanding the Alpha Beta Sigma Fraternity 271 The Random Walk Revisited 277 A New Investment Paradigm 282 The Quant Meltdown of August 2007 283 Forensic Finance 284 Adaptive Markets and Liquidity Spirals 289 1998 versus 2007 292 9 Fear, Greed, and Financial Crisis 296 Ecosystem Ecology 296 Financial Crisis 101 298 Clear as Rashomon 301 Not Enough Skin in the Game? 303 Regulators Asleep at the Wheel? 306 Red Pill or Blue Pill? 312 Could We Have Avoided the Crisis? 314 The Adaptive Markets Hypothesis Explains 318 (Ab)Normal Accidents 320 Liquidity Withdrawal Symptoms 324 10 Finance Behaving Badly 330 Finance Rules 330 Out-Ponzi-ing Ponzi 332 The Ultimatum Game 335 A Neuroscience of Morality? 338 Is Finance Fair? 340 Finance and the Gordon Gekko Effect 345 Regulatory Culture 349 Environment Strikes Again 352 Moore's Law versus Murphy's Law 355 The Tyranny of Complexity 361 11 Fixing Finance 365 An Ounce of Prevention 365 Ecosystem Management 366 Adaptive Regulation 368 Law Is Code 371 Mapping Financial Networks 375 The CSI of Crises 378 Privacy with Transparency 384 Anti-Gekko Therapies 387 12 To Boldly Go Where No Financier Has Gone Before 395 Star Trek Finance 395 "Computer, manage my portfolio!" 397 Curing Cancer 400 Eliminating Poverty 411 A New Narrative 415 I Want To Be Harvey Lodish 418 Notes 421 References 439 Acknowledgments 463 Index 469

About the Author

Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. He is the author of Hedge Funds and the coauthor of A Non-Random Walk Down Wall Street and The Econometrics of Financial Markets (all Princeton). He is also the founder of AlphaSimplex Group, a quantitative investment management company based in Cambridge, Massachusetts.

Reviews

"Mr. Lo makes a convincing argument and he also uses the book to lay out some interesting ideas--such as a huge, diversified fund that would invest in a range of potential cancer treatments."--Economist "[A] remarkable new book... Lo's book will be read and read widely... His insights should allow investors and regulators alike to manage risks better. They should read it."--John Authers, Financial Times "This new book will become another essential read for anybody interested in financial markets... [It] is a thoroughly interesting and enjoyable read. It is not technical, the explanations are super-clear, and there is some excellent story telling."--Enlightened Economist "[Lo] has a knack for providing a telling anecdote or story to illustrate his point. More important, he also avoids being condescending or triumphalist."--Matthew Partridge, Money Week "Using research in evolutionary biology, psychology, neuroscience and artificial intelligence, Mr. Lo ... explains how human behavior shapes the markets, leading to swings between stability and instability, profit and loss, innovation and regulation."--Pensions & Investments

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