15.

481x Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Unit 1: Introduction and Financial Orthodoxy

Lecture: The Power of Economics and Finance

 The Power of
Economics and
Finance
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Nobel Laureates Fama, Hansen, and Shiller

Markets are except when and quantitative

efficient… they aren’t… tools can help tell
the difference.
Wisdom of Madness Power of
Crowds of Mobs Quant
© 2020 by Andrew W. Lo
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 15.481
Foundations of Modern Economics
Origins of Modern Economics
§ Physics (Samuelson, 1947)
§ Samuelson (1998):
Perhaps most relevant of all for the genesis of Foundations, Edwin Bidwell Wilson (1879–
1964) was at Harvard. Wilson was the great Willard Gibbs's last (and, essentially only)
protege at Yale. He was a mathematician, a mathematical physicist, a mathematical
statistician, a mathematical economist, a polymath who had done first-class work in
many fields of the natural and social sciences. I was perhaps his only disciple… I was
vaccinated early to understand that economics and physics could share the same formal
mathematical theorems (Euler's theorem on homogeneous functions, Weierstrass's
theorems on constrained maxima, Jacobi determinant identities underlying Le Chatelier
reactions, etc.), while still not resting on the same empirical foundations and certainties.
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Founda:ons of Modern Economics
Principle of Least Action/Maximum Utility
§ A particle will follow a trajectory that minimizes “action”
§ An individual will behave so as to maximize “utility”
§ Actor need not be “aware” of optimization
§ Theory is predictive
§ Logical positivism
§ Friedman (1953) “positive economics”, K. Popper
§ “Physics envy” (or “math envy”)
Source: wikipedia

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Foundations of Modern Economics
Physics Approach In Economics Led To:
§ U"lity theory, revealed preference (Samuelson)
§ General equilibrium theory (Arrow, Debreu)
§ Game theory (Harsanyi, Nash, Selten, Shapley)
§ Macroeconometrics (Klein, Tinbergen)
§ PorGolio theory (Markowitz, Tobin)
§ Ra"onal expecta"ons (Lucas, Muth, Sargent)
§ Op"on-pricing theory (Black, Merton, Scholes)
§ Efficient markets (Fama, Samuelson)
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Foundations of Modern Economics
Physics Approach In Economics Led To:
Before the contemporary period of the past five
decades, theoretical physics had been an
inaccessible ideal toward which economic theory
sometimes strove. During that period, this striving
became a powerful stimulus in the mathematization
of economic theory.
– G. Debreu (1991, AEA Presidential Address)

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Foundations of Modern Economics
Theory
Economic
of Theory
Economic
of Behavior Homo Economicus

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Critique of Modern Economics
But Economics Was/Is Too
“The silliness of theories such asImportant and Successful
ra1onal addic1on theory raises
the ques1on of how they can§ be National
takenEconomic
seriously.Council
I suggest an
§ Council
explana1on based on the rela1ve of Economic Advisors
impenetrability of
§ Federal Reserve
mathema1cal arguments as compared to verbal
§ U.S. Treasury, OCC
arguments, the
psychological feeling of understanding
§ SEC, CFTC,triggered
FDIC by the stories
included in the ar1cles, along§ with the neglect
Wall Street, of some of the
corporations
underlying issues by the economics profession.”
§ Business schools
§ etc.

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 15.481
Foundations of Modern Economics

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Lecture 1 Slide 10
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 15.481
Foundations of Modern Economics

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Lecture 1 Slide 11
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The Beauty of Microeconomics
Survival Requires Consumption of Resources Over Time
§ Consumption, savings, and production are key decisions
§ They are constrained by technology and economic conditions
§ The challenge is to survive and reproduce!
§ Financial markets are critical in meeting this challenge
§ HOW?

Consider The “Calculus of Consumption”

1. Preferences given by a “complete preference ordering”
– Completeness means that for any two choices A and B:

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 15.481
The Beauty of Microeconomics
Consider The “Calculus of ConsumpCon”
2. More is preferred to less (non-sababon, free disposal)
3. Transibvity:
4. Diminishing marginal returns
§ These axioms have surprisingly specific implicabons
B
(A3,B3) (A2,B2)

(A1,B1)
A
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The Beauty of Microeconomics
Consider The “Calculus of Consumption”
§ Consider the set of consumption bundles (A,B) that are as
equally satisfying as (A1,B1)
§ This is called an indifference curve
U3
U1 U2 Bliss
B B U1

(A1,B1)
A A

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 15.481
The Beauty of Microeconomics
Consider The “Calculus of Consumption”
§ Can the following set of indifference curves be
possible?
U1U
B 2

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 15.481
The Beauty of Microeconomics
Consider The “Calculus of Consumption”
§ Objective: Maximize utility subject to your available
resources
U1
B U0

(A1,B1)

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 15.481
The Beauty of Microeconomics
Consider The “Calculus of Consumption”
§ What if markets for goods A and B exist, as well as money?
§ What does “markets exist” mean?
§ First determine your total wealth W = paA1 + pbB1 , then
choose the best (A,B) pair

B U1
Budget Constraint

(A1,B1)

A
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 15.481
The Beauty of Microeconomics
Markets Unambiguously Makes Everyone Better Off!
U*
B

(A*,B*)

§ “Chicago School”, Milton Friedman, Libertarianism, etc.

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The Beauty of Microeconomics
Now Suppose A Can Be Consumed or Used To Produce B
§ How much of Ao should we consume vs. use to produce B?
§ First, we must identify the production possibility frontier (PPF)
§ Depends on technology U*

B
(A*,B*)

A
I
Ao
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 15.481
The Beauty of Microeconomics
Now Suppose We Have Markets and ProducCon CapabiliCes
§ How much of Ao should we invest and use to produce B?
§ How much of Ao should we consume?
U*
Effective Separation of Ownership and
B Control (Shareholder Values)
(A*,B*)
§ Shareholders want optimal investment and
production (A†,B†)
§ Then use markets to attain (A*,B*)
(A†,B†) § No need to specify shareholder preferences
§ “Maximize my opportunity set”
A
Ao
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 15.481
The Beauty of Microeconomics
What Is The Purpose of “Shareholder Values”?
§ Mechanism through which 3 C’s is possible:
– Communication, Coordination, Collaboration
§ Large-scale projects can be accomplished (Airbus A380)
§ Great challenges can be overcome (Manhattan Project)
§ Facilitates resource allocation through prices
§ Does not rely on centralized controls (but does require “leadership”)
§ This is a form of “collective intelligence”
§ Organizations are “smarter” than individuals
§ Do you believe that markets “work”? Marxism vs. Capitalism

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But Is It Correct?

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Rational Expectations
and Efficient Markets
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Price Dynamics and the Hog Cycle
Price Supply

Demand
1. Start at Q0, Expected Price P0
2. Actual Price P1
P1 3. Yields Supply Q1
P*
P2 4. Actual Price P2
P0
5. Spirals Unbl…
6. Supply = Demand!

Quantity
Q0 Q2 Q* Q1

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Price Dynamics and the Hog Cycle
Price
Supply
Demand
In This Special Case:
§ Infinite cycles
P1
§ Price oscillates
P0 § Quantity oscillates
§ Demand ¹ Supply
Quantity
Q0 Q1

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 15.481
Price Dynamics and the Hog Cycle
Price

Demand Supply
In This Special Case:
§ Market is unstable
§ Outward spiral
§ Market collapses
eventually
Quantity
Q0

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 15.481
Price Dynamics and the Hog Cycle
John
Market Dynamics Involve Expectations: Muth

Price Supply
Demand

P*

Robert
Lucas

Are Markets Adaptive or Rational? Q*

Quantity

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 15.481
The Efficient Markets Hypothesis
Theory of Market Efficiency:
§ Samuelson (1965), Fama (1965, 1970)
§ No Free Lunch, No Arbitrage
§ Prices Fully Reflect All Available Information
§ Prices Follow Random Walks
§ Technical Analysis Is Futile
§ Trade-Off Between Risk and Expected Return
§ “Active” Management Does Not Add Value

“The Wisdom of Crowds”, “The Invisible Hand”

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 15.481
The Efficient Markets Hypothesis
January 28, 1986, 11:39am
§ 11:47am: ‘‘Space Shuttle Explodes’’
§ 12:17pm: ‘‘Lockheed Has No
Immediate Comment’’
§ 12:52pm: ‘‘Rockwell Intl Has No
Comment’’

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The Efficient Markets Hypothesis
Reagan Establishes Presidential Commission To Investigate

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The Efficient Markets Hypothesis
Rogers Commission Report Published June 9, 1986
§ Concluded that booster rocket O-ring was the problem
O-Ring

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The Efficient Markets Hypothesis

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The Efficient Markets Hypothesis
The Stock Market Reflected This Information Within Minutes

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The Efficient Markets Hypothesis

© 2020 by Andrew W. Lo
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The Wisdom of Crowds

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The Madness of Mobs

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Next Time

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Lecture 1 Slide 37
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