Adaptive market hypothesis

The Adaptive Market Hypothesis, as proposed by Dr. Andrew Lo (2004), is a new framework that reconciles theories that imply that the markets are efficient with behavioral alternatives, by applying the principles of evolution - competition, adaptation, and natural selection - to financial interactions.

Under this approach the traditional models of modern financial economics can coexist alongside behavioral models in an intellectually consistent manner. He argues that much of what behavioralists 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.

According to Lo, the Adaptive Markets 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 (i.e. pension funds, retail investors, market makers, and hedge-fund managers, etc.). If multiple members of a single group 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 reflects 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. 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 (Lo,2005).

Implications

The AMH has several implications that differentiate it from the EMH such as:
# To the extent that a relation between risk and reward exists, it is unlikely to be stable over time.
# Contrary to the classical EMH, arbitrage opportunities do exist from time to time.
# Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. This includes quantitatively-, fundamentally- and technically-based methods.
# Survival is the only objective that matters while profit and utility maximization are secondary relevant aspects
# Innovation is the key to survival because as risk/reward relation varies through time, the better way of achieving a consistent level of expected returns is to adapt to changing market conditions.

References

* [http://web.mit.edu/alo/www/Papers/JPM2004.pdf Lo, Andrew (2004): "The Adaptive Market Hypothesis; market efficiency from an evolutionary perspective"]