Andrew Lo's Adaptive Market Hypothesis is an attempt to update MPT. His theory "in a nutshell is a reinterpretation of efficient markets and behavioral finance in the context of evolution and natural selection in a way that reconciles the two theories in an intellectually satisfying manner," explains Lo, who is the Harris & Harris Group Professor at the MIT Sloan School of Management as well as chairman and chief investment officer of Alphasimplex, a money management firm that invests based on Adaptive Market principles. "The MPT model is not wrong, it's just incomplete."

This is because markets have evolved in many ways far beyond where they were when Markowitz introduced his theory. Lo claims that many tenets of MPT-holding stocks for the long haul, sufficient diversification across stocks and bonds, the relationship between risk and return-haven't held up.

His idea is that markets are not efficient, but adaptive. The increasing pace of technology, the growth of populations and economies and the ongoing innovation in financial products and strategies all continue to alter the investing framework. There are no immutable underlying principles in economics as there are in physics, Lo says. "Darwin has more to do with economics than Adam Smith."

Where MPT posits a rational investor, Lo argues for an investing public that swings between common sense and mob madness. During times of crisis, investors act out of the baser biological instinct to fight or flee, rather than the cerebral cortex's measured reasoning. The market therefore seesaws between emotion and logic, underlying the shifts between value and growth.

"You need to understand that value is when markets are behaving rationally and growth is when something else is going on," Lo says. "Someone wise once said 'Market prices are rarely correct, but they should never be ignored.'" In other words, neither value nor growth is better, but that you have to know what kind of market you're in and act accordingly. For example, famed investors Warren Buffett and Julian Robertson both saw the bubble in the dotcom boom. But while Buffett chose to sit on the sidelines and clean up later, Robertson shorted tech stocks about six months too soon and lost his shirt. "Don't blindly assume one way is right," says Lo. "You have to constantly adjust to the market."

The much greater amount of assets in the world (there's 50 times more money in 2007 than there was in 1998), which corresponds to a much larger population, creates washes of liquidity that competes for investments. As a result, alpha is constantly spawning new betas because any successful alpha strategy is mimicked. "Alpha gets copied so much it becomes beta," says Lo. "It goes from being unique to being common." So investors have to be aware of many betas, not just one or two or three.

So investors can no longer manage risk through long-term asset allocation, but by understanding volatility and rebalancing frequently across a range of assets and strategies ranging from indexing to hedge funds.

The way we approach markets today is synonymous with the parable of the blind monks and the elephant: one touches the trunk and believes the animal looks like a snake while the other touches the leg and believes the animal is built like a tree. Lo is trying to bring disparate views of the same market together into one "ecology, where we learn the ever-evolving flora and fauna." Flourishing in the market's world is a function of understanding how that whole ecosystem works.