A new book by MIT Professor Andrew Lo brings forward a theory on market dynamics called the adaptive markets hypothesis. Lo suggests this theory adapts thinking from the efficient market hypothesis (EMH) and reconciles the EMH with the reality of markets and human behavior. I had the pleasure of interviewing Professor Lo last week on our “Behind the Markets” podcast with Wharton Professor Jeremy Siegel.

Lo also used to be a Wharton professor, and Professor Siegel recalled fond memories of Lo’s early days at Wharton. Siegel also clearly had an impact on Lo, and Lo’s adaptive markets hypothesis takes some root in consideration of Siegel’s Stocks for the Long Run. While Lo believes stocks are good investments over the long run, the human tendency to panic in the short run makes sticking with stocks long term difficult. This is a challenge for Lo, who sees the market as having efficiencies that make it tough to systematically outperform but also leave it vulnerable to episodes in which fear and greed rotate with some irrational behavior.

One formula Lo used in writing about the adaptive markets hypothesis, according to his publisher: “Every formula in the book would yield readership that would be divided by 2.” So while his new book has a good amount of length, Lo wrote it to appeal also to a broader, nontechnical audience.

The EMH Democratized Finance but Brought New Risks

Lo discussed how the EMH ushered in the trend toward low-cost passive indexing and was a beneficial move away from actively trying to pick winners and losers. We had an extended conversation on the adaptive markets hypothesis’ implications for passive investing and whether too much was passively invested. The short answer from Lo: Not yet. But he does believe the trend toward passive investing is bringing about new systematic risks and liquidity risks and herding in markets so that when everyone wants to get out, the rush to exit will be a problem.