My guest today is Andrew Lo, the 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.
The topic is his book Adaptive Markets: Financial Evolution at the Speed of Thought.
In this episode of Trend Following Radio we discuss:
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]
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.
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.