Adaptive market hypothesis
Encyclopedia
The adaptive market hypothesis, as proposed by Andrew Lo
, is an attempt to reconcile economic theories based on the efficient market hypothesis
(which implies that market
s are efficient) with behavioral economics, by applying the principles of evolution
to financial interactions: competition
, adaptation
and natural selection
.
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 bias
es—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics.
By species
, he means distinct groups of market participants, each behaving in a common manner—pension fund
managers, retail investors, market maker
s, 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.
Andrew Lo
Andrew W. Lo is the Harris & Harris Group Professor of Finance at the MIT Sloan School of Management. He is a leading authority on hedge funds and financial engineering; he proposed the Adaptive market hypothesis...
, is an attempt to reconcile economic theories based on the efficient market hypothesis
Efficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...
(which implies that market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
s are efficient) with behavioral economics, by applying the principles of evolution
Evolution
Evolution is any change across successive generations in the heritable characteristics of biological populations. Evolutionary processes give rise to diversity at every level of biological organisation, including species, individual organisms and molecules such as DNA and proteins.Life on Earth...
to financial interactions: competition
Competition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
, adaptation
Adaptation
An adaptation in biology is a trait with a current functional role in the life history of an organism that is maintained and evolved by means of natural selection. An adaptation refers to both the current state of being adapted and to the dynamic evolutionary process that leads to the adaptation....
and natural selection
Natural selection
Natural selection is the nonrandom process by which biologic traits become either more or less common in a population as a function of differential reproduction of their bearers. It is a key mechanism of evolution....
.
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
Loss aversion
In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains....
, overconfidence
Overconfidence effect
The overconfidence effect is a well-established bias in which someone's subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high. For example, in some quizzes, people rate their answers as "99% certain" but are wrong...
, overreaction, and other behavioral bias
Bias
Bias is an inclination to present or hold a partial perspective at the expense of alternatives. Bias can come in many forms.-In judgement and decision making:...
es—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics.
Details
According to Lo, the adaptive market hypothesis can be viewed as a new version of the efficient market hypothesis, derived from evolutionary principles:By species
Species
In biology, a species is one of the basic units of biological classification and a taxonomic rank. A species is often defined as a group of organisms capable of interbreeding and producing fertile offspring. While in many cases this definition is adequate, more precise or differing measures are...
, he means distinct groups of market participants, each behaving in a common manner—pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
managers, retail investors, market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s, hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
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
Italian Renaissance
The Italian Renaissance began the opening phase of the Renaissance, a period of great cultural change and achievement in Europe that spanned the period from the end of the 13th century to about 1600, marking the transition between Medieval and Early Modern Europe...
).
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
Ecology
Ecology is the scientific study of the relations that living organisms have with respect to each other and their natural environment. Variables of interest to ecologists include the composition, distribution, amount , number, and changing states of organisms within and among ecosystems...
, such as the number of competitors in the market, the magnitude of profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
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:- To the extent that a relation between riskFinancial riskFinancial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
and reward exists, it is unlikely to be stable over time. - There are opportunities for arbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
. - Investment strategies—including quantitativelyMathematical financeMathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical...
, fundamentallyFundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
and technicallyTechnical analysisIn finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
based methods—will perform well in certain environments and poorly in others. - The primary objective is survivalSurvivalSurvival is the struggle to remain alive and living. The term may refer to:- Companies and organisations :* Survival International, a non-governmental human rights organization working for tribal peoples- Literature :...
; profitProfit (economics)In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
and utilityUtilityIn economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
maximization are secondary. - The key to survival is innovationInnovationInnovation is the creation of better or more effective products, processes, technologies, or ideas that are accepted by markets, governments, and society...
: as the risk/reward relation varies, the better way of achieving a consistent level of expected returnExpected returnThe expected return is the weighted-average outcome in gambling, probability theory, economics or finance.It isthe average of a probability distribution of possible returns, calculated by using the following formula:...
s is to adapt to changing market conditions.