It Takes a Theory to Beat a Theory, or the Trouble with Tribbles

Laurence Articles

Is the market efficient? Of course not — not exactly, or not even close, depending on your point of view. However, the efficient market hypothesis (EMH), while self-evidently not quite correct, has remained surprisingly resistant to overturning. The reason is that, as MIT professor Andrew W. Lo says repeatedly in his new book, Adaptive Markets, “it takes a theory to beat a theory.” And, up to this point, there has been no alternative theory that can substitute for the EMH if the latter is found wanting.

In the modern study of capital markets there have been two kinds of innovation: (1) insights that contribute to our ability to make better judgments, as found in the brilliant work of Fischer Black, Peter Bernstein, Marty Leibowitz, and many others; and (2) true hypotheses and theories, which are testable and, as I’ll explain shortly, falsifiable. The latter are few and far between. Andrew Lo’s book aims to present a new theory of capital markets, but, while it does not really do so, it is full of brilliant insights into behavior, evolution, and the ways in which these factors help us to better understand how capital markets work.

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