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Ep 569: Andrew Lo Interview with Michael Covel on Trend Following Radio

Andrew Lo
Andrew Lo

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Andrew Lo is author of “Adaptive Markets: Financial Evolution at the Speed of Thought.” He is also the Charles E. and Susan T. Harris Professor of Finance at MIT and the chairman and chief investment strategist of the AlphaSimplex Group.

Andrew was taught from the beginning of his career that the efficient market hypothesis was gospel truth. It was the end-all-be-all. However, he first found a problem with the efficient market hypothesis just after graduating college. He did a test on the “random walk hypothesis” and related his findings from that hypothesis to the markets. He then came to find that his results proved the efficient market hypothesis wrong. Was there pushback during the early stages of talking about EMT being wrong? Absolutely. Andrew was one of the strongest that pushed back primarily because it went against everything he previously knew to be true.

Andrew talks about another study he did with one of his MIT classes in 2004. He looked at hedge funds around that time and through data he proved that they were headed for trouble. They were able to foresee a small piece of the 2008 crash. Michael and Andrew end the podcast talking about Andrew’s new book and the role that the environment is playing in adaptive markets. When studying a species, what should be asked is, “Is it the species that is complex, or is it the environment that is complex and the species is just adapting to it?” Many species have figured out how to live in harsh environments in very different ways. In the same light, there are many different ways that people can trade the market and be successful.

In this episode of Trend Following Radio:

  • Efficient market hypothesis
  • Adaptive markets hypothesis
  • The random walk hypothesis
  • Crowded trade phenomenon
  • 2008 meltdown
  • Paul Samuelson
  • Commodities Corporation

Mentions & Resources:

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Feedback in:

Dear Michael,

Your website is as interesting and informative as ever. Thanks for all the insights you continue to provide to the members of the trend following tribe. Thought I would share an interesting anecdote about [one of] this year’s Nobel Prize in economics. A well regarded trend follower in Mumbai [India], while expressing incredulity at the selection of Eugene Fama (of “Efficient Markets Fame”) for this years Nobel Prize, quipped to me that this recognition will ensure that trend following survives for a very very long time.” [name]

Good point.

“The overwhelming fact is that this thing that shouldn’t have worked has worked for 30 years.”

An excerpt:

To see how trend-followers aren’t all about rocket science, take one of the forefathers of today’s fund managers: Chicago-based trader Richard Dennis. In the 1980s, he made a bet with a rival that successful traders could be taught, that it wasn’t an innate talent. As part of the contest, Dennis taught a breed of traders he called ‘Turtles’ because he trained them to lock into specific market trends and ride them, just as turtles ride sea currents. What was important was to decide on a system and stick with it. The approach lends itself to computerized dealing, because in it, trades are often triggered by the dynamics of the market itself. A classic example is the moving average. Track the five-day moving average of a stock and, some traders believe, you should buy where it crosses above the 30-day average or sell when it falls below. Such ideas can be converted into an algorithm that tells a computer when and how to trade. The turtles’ edge, like trend-followers today, was in exploiting the reality that mainstream economic theory doesn’t allow for: financial markets don’t behave efficiently, but follow vogues and panics. “The overwhelming fact is that this thing that shouldn’t have worked has worked for 30 years,” said Harding over lunch at his local West London Italian restaurant. Computers don’t need to be persuaded to hold firm when the market turns against them.

Well stated.

Efficient Markets: Killing Off the Monster

From the Economist:

Having lived through the financial crisis of 2007-08, the man in the street might find the idea that markets are “efficient” incredible. But the efficient-market hypothesis, like a Hollywood monster, has proved very hard to kill off. From the truism that the average investor could not beat the market after costs, academics developed the insight that obvious market-beating opportunities would quickly be arbitraged away.

Here is a great example of efficient markets — not:

That chart could only have been effectively traded as a trend following trader. You used fundamentals to trade that? You are full of it or you were flipping coins and hit heads.

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