Adaptive Markets Hypothesis

What is Adaptive Market Hypothesis?

The adaptive market hypothesis (AMH) comes from the works of Andrew Lo from 2004. This hypothesis brings together the principles of the efficient market hypothesis (EMH) and behavioural finance. It does so by applying the principles of evolution to financial interactions. These principles include adaptation, competition, and natural selection.

In economics, most traditional financial economics theories contradict the principles set forth by behavioural models. However, with the help of the adaptive market hypothesis, these models can coexist. This theory applies the evolutionary biology framework to specific financial concepts.  Similarly, AMH has five principles, which it suggests are crucial for adaptive markets.

What are the two parts of the Adaptive Market Hypothesis?

As mentioned, the adaptive market hypothesis brings the efficient market theory and behavioural finance. Although these have contradicting views, AMH seeks to explain how these apply to practical situations. A brief description of each of these is as below.

Efficient Market Hypothesis

One of the core parts of the adaptive market hypothesis is the efficient market hypothesis, or simply, the efficient market theory. This theory suggests that all stock prices reflect all information. Therefore, stocks will always trade at their fair value on stock exchanges. It further implies that investors can’t benefit from overvalued or undervalued stocks.

Behavioural Finance

Behavioural finance is a field of behavioural economics, which suggests that psychological influences and biases can affect investor's financial behaviours. Furthermore, it seeks to explain how these influences and biases cause market anomalies. Behavioural finance also proposes that investors are irrational in their decision-making.

What are the principles of the Adaptive Market Hypothesis?

The adaptive market hypothesis has five basic principles. These include the following.

• Individuals act in their own self-interest.
• Individuals make mistakes.
• Individuals learn from the mistakes they make; they adapt, and then they innovate.
• During these innovations or experimentations, the process of natural selection will apply to individuals, institutions, or markets.
• This evolutionary process determines financial market dynamics.

How does the Adaptive Market Hypothesis work?

The adaptive market hypothesis seeks to consolidate the principles of the efficient market theory with behavioural finance. EMH implies that investors are rational and efficient. However, this view comes as a contradiction to the principles of behavioural economics, which suggest they are irrational and inefficient. Both of these beliefs are the complete opposite of each other.

The adaptive market hypothesis further suggests that people are primarily rational. However, they may act or become irrational in some cases. These cases usually involve a reaction to new opportunities opening up or fluctuations in market volatility. The theory also implies that people always act in their self-interest, which is one of its principles.

During their activities, people may commit several mistakes. However, AMH suggests that people learn from those mistakes. Then, they adapt accordingly. They make best guesses based on trial and error. Every time their tactic fails, they will take a different approach next time. If it succeeds, they will use a similar strategy again. This way, the process of natural selection occurs.

Conclusion

The adaptive market hypothesis combines the principles presented by the efficient market hypothesis and behavioural finance. While the efficient market hypothesis states that investors are rational, behavioural finance suggests otherwise. AMH proposes five principles and seeks to apply the evolutionary biology framework to specific finance concepts.

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