Adaptive Market Hypothesis (AMH)
The Adaptive Market Hypothesis (AMH) is an economic theory proposed by Andrew Lo in 2004. The AMH provides a new framework from which to understand financial markets. The theory tries to reconcile the Efficient Market Hypothesis (EMH) and behavioral finance.
The AMH borrows extensively from other scientific fields. For example, a cornerstone of the AMH is based on the notion that market participants, in order to survive, continuously need to adapt. This is very similar to the survival of the fittest concept proposed by Darwin (evolution theory). Of course, adaptation is nothing new in finance and economics. In a way, the adaptive market hypothesis is therefore similar to Schumpeter’s creative destruction.
Andrew Lo argues that a lot of the behavior described by behavioral economists is consistent with market participants’ adaptive behavior in financial markets. For example, investors try out strategies. The ones that fail, they don’t repeat. The strategies that work however, investors continue to apply. Thus, a number of observed behavioral biases in finance may follow from investors behaving adaptively or evolutionary.
On this page, we look at some of the elements that define the AMH, discuss the implications of the adaptive market hypothesis for investors, and summarize the main takeaways.
Adaptive Market Hypothesis insights
The AMH argues that the degree of market efficiency depends on the number of market participants chasing alpha. For example, the more ‘species’ are chasing returns in a particular market, the more efficient the market becomes. Similarly, a market for securities in which few participants are active will probably allow investors to generate alpha more easily. Second, the ‘environment’ also matters. For example, the more liquid a market, the more efficient the market as it attracts more market participants. Third, the degree to which the species can adapt also matters. The quicker investors adjust their strategies to new valuable information, the quicker profit opportunities will disappear.
Implications adaptive market hypothesis
What does the adaptive market hypothesis tell us about investing? Does it imply an adaptive asset allocation? Should we start applying ‘adaptive’ portfolio management?
There are a number of important takeaways from the adaptive market hypothesis.
- First, while there are plenty opportunities in financial markets, unlike what the EMH says, we can expect these to be increasingly exploited over time. As that happens, investors should adapt. This means that strategies that generate alpha should be monitored and should be adapted continuously. If investors don’t maintain their investing approach and don’t improve it, they can expect their alpha to go down over time. This is because the opportunity is picked up by more and more investors. Thus, the risk/return trade-off evolves over time and alpha opportunities can be expected to disappear over time.
- A second implication is that different trading strategies can perform in different markets, depending on the ‘species’ active in it and the environment. Third, investors trade to generate income, not to maximise profits or maximise utility. This would explain why investors exhibit risk aversion. Instead of maximising their profits, investors prefer to realise profits even if that means that their behaviour is sub-optimal.
- Finally, as we discussed already above, the key to survival is innovation. Investors need to be able and willing to adapt their approaches over time if they want to survive.
Summary
The AMH leads to 5 conclusions
- The relationship between risk and return need not be stable
- Active management can find opportunities to exploit and and add value
- No strategy should work all of the time
- Adaptation and innovation are crucial for continued success
- Survivors are those investors that change and adapt