Adaptive market hypothesis

The adaptive market hypothesis, as proposed by Andrew Lo,^[1] is an attempt to reconcile economic theories based on the efficient market hypothesis (which implies that markets are efficient) with behavioral economics, by applying the principles of evolution to financial interactions: competition, adaptation and natural selection.^[2]

Under this approach, the traditional models of modern financial economics can coexist with behavioral models. Lo argues that much of what behaviorists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics.

Details

According to Lo,^[3] the adaptive market hypothesis can be viewed as a new version of the efficient market hypothesis, derived from evolutionary principles:

Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of "species" in the economy.

By species, he means distinct groups of market participants, each behaving in a common manner—pension fund managers, retail investors, market makers, hedge fund managers, etc.

If multiple members of a single group are competing for rather scarce resources within a single market, then that market is likely to be highly efficient (for example, the market for 10-year U.S. Treasury notes, which reflects most relevant information very quickly indeed). On the other hand, if a small number of species are competing for rather abundant resources, then that market will be less efficient (for example, the market for oil paintings from the Italian Renaissance).

Market efficiency cannot be evaluated in a vacuum, but is highly context-dependent and dynamic. Shortly stated, the degree of market efficiency is related to environmental factors characterizing market ecology, such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants.

Implications

The adaptive market hypothesis has several implications that differentiate it from the efficient market hypothesis:

1. To the extent that a relation between risk and reward exists, it is unlikely to be stable over time.
2. There are opportunities for arbitrage.
3. Investment strategies—including quantitatively, fundamentally and technically based methods—will perform well in certain environments and poorly in others.
4. The primary objective is survival; profit and utility maximization are secondary.
5. The key to survival is innovation: as the risk/reward relation varies, the better way of achieving a consistent level of expected returns is to adapt to changing market conditions.

See also

• Adaptive expectations
• Agent-based computational economics
• Financial economics #Challenges and criticism
• Information cascade
• Noisy market hypothesis
• Random walk hypothesis #A non-random walk hypothesis

Notes

References

• Lo, Andrew (2004). "The Adaptive Market Hypothesis: Market Efficiency from an Evolutionary Perspective" (pdf). Journal of Portfolio Management. 5. 30: 15–29. 
• Lo, Andrew (2005). "Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis".