Prof Andrew Lo: what’s wrong with the “traditional investment paradigm”?


I will, gladly, let Andrew Lo explain in great detail. A link to his paper follows this extract BUT I have highlighted something that, to me, is pretty fundamental…attempting to model a non-linear future based upon a past of, patently flawed, assumptions!:

The traditional investment paradigm is based on several key assumptions including rational investors, stationary probability laws, and a positive linear relationship between risk and expected return with parameters that are constant over time and which can be accurately estimated. These assumptions were plausible during the “Great Modulation” — the seven decades spanning the mid-1930s to the mid-2000s in which equity markets exhibited relatively stable risk and expected returns — but have broken down during the past decade, implying temporary but significant violations of rational pricing relationships. This tension between rational and behavioural market conditions is captured by the Adaptive Markets Hypothesis (AMH), an evolutionary perspective on market dynamics in which intelligent but fallible investors learn from and adapt to changing environments. Under the AMH, markets are not always efficient, but they are highly competitive and adaptive, and can vary in their degree of efficiency as the economic environment and investor population change over time.

via Adaptive Markets and the New World Order

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