Adaptive Market Hypothesis

On surfing, I came across this term ‘Adaptive Market Hypothesis’. I got interested and decided to do some research. Andrew Lo, an MIT Prof. has coined the term. I know him as he has written the famous book- Econometrics of Financial Markets.  

So what is this AMH? He has written couple of papers on the subject. This is the paper I read. The abstract says it all:

One of the most influential ideas in the past 30 years of the Journal of Portfolio Management is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution—competition, adaptation, and natural selection—to financial interactions. By extending Herbert Simon’s notion of “satisficing” with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.

This is one of the few papers in finance, which is without all that maths and statistics jazz. It is a paper that gives an idea on the way new developments in finance should be understood and further research would be needed.

So how does one reconcile the 2 divergent streams of finance (i.e. EMH and BF):

Specifically, the Adaptive Markets Hypothesis can be viewed as a new version of the EMH, derived from evolutionary principles. Prices react as much information as dictatedby the combination of environmental conditions and the number and nature of species” in the economy or, to use the appropriate biological term, the ecology.

By species, I mean distinct groups of market participants, each behaving in a common manner. For example, pension funds may be considered one species; retail investors, another; marketmakers, a third; and hedge-fund managers, a fourth. If multiple species (or the members of a single highly populous species) are competing for rather scarce resources within a single market, that market is likely to be highly efficient, e.g., the market for 10-Year US treasury Notes, which reacts most relevant information very quickly indeed.

If, on the other hand, a small number of species are competing for rather abundant resources in a given market, that market will be less efficient, e.g., the market for oil paintings from the Italian Renaissance. Market efficiency cannot be evaluated in a vacuum, but is highly context-dependent and dynamic, just as insect populations advance and decline as a function of the seasons, the number of predators and prey they face, and their abilities to adapt to an ever-changing environment.

Wow! that makes finance so exciting. Read the whole thing as it is a great paper which builds on views of leading economists and their philosophies. Now, what about the practical implications, as that is what matters:

1. The first implication is that to the extent that a relation between risk and reward exists, it is unlikely to be stable over time. Such a relation is determined by the relative sizes and preferences of various populations in the market ecology, as well as institutional aspects such as the regulatory environment and tax laws. As these factors shift over time, any risk/reward relation is likely to be affected. A corollary of this implication is that the equity risk premium is also time-varying and path-dependent…..

2. Contrary to the classical EMH, arbitrage opportunities do exist from time to time in the AMH.

3. Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. Contrary to the classical EMH in which arbitrage opportunities are competed away, eventually eliminating the profitability of the strategy designed to exploit the arbitrage, the AMH implies that such strategies may decline for a time, and then return to profitability when environmental conditions become more conducive to such trades.

 4. Innovation is the key to survival. The classical EMH suggests that certain levels of expected returns can be achieved simply by bearing a sufficient degree of risk. The AMH implies that the risk/reward relation varies through time, and that a better way of achieving a consistent level of expected returns is to adapt to changing market conditions. By evolving a multiplicity of capabilities that are suited to a variety of environmental conditions, investment managers are less likely to become extinct as a result of rapid changes in business conditions.

5. The AMH has a clear implication for all financial market participants: survival is the only objective that matters. While profit maximization, utility maximization, and general equilibrium are certainly relevant aspects of market ecology, the organizing principle in determining the evolution of markets and financial technology is simply survival.

This is a must read for all finance professional. It helps build and develop new perspectives. This is what research is all about.

4 Responses to “Adaptive Market Hypothesis”

  1. Amin Says:

    I want to decide to write my finance master thesis about Adaptive Market Hypothesis., but honestly speaking, I do not know me how much econometrics and stochastic processes knowledge do I need? So, I would be grateful if you could mention some literatures that contain minimum requirements.

  2. Editors Says:

    Hold-On “Mostly Economics”

    There have been two major declines over the past eight years, and the stock market is on pace to underperform every decade over the past century, including the 1930s.

    During this time, modern portfolio theory [MPT] represented the investment methodology most widely employed by financial advisors. It mandated a strategy of allocating funds to a wide array of asset classes in an effort to lower risk. The goal was to identify low or even negatively correlated assets that would allow a portfolio to withstand the most severe declines.

    But, I’m not so sure the theory has worked; do you?

    Dr. David Edward Marcinko; FACFAS, MBA

  3. Muhammad Asad Khan Says:

    I am a student of PhD in finance and interested to work on the adaptive market hypothesis. please give me some idea to start work on.

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