Adaptive Market Hypothesis (AMH)

What Is Adaptive Market Hypothesis (AMH)?

The adaptive market hypothesis (AMH) is an alternative economic theory that combines principles of the well-known and often controversial efficient market hypothesis (EMH) with behavioral finance. It was introduced to the world in 2004 by Massachusetts Institute of Technology (MIT) professor Andrew Lo.

Understanding the Adaptive Market Hypothesis (AMH)

The AMH attempts to marry the theory posited by the EMH that markets are rational and efficient with the argument made by behavioral economists that they are actually irrational and inefficient.

For years, the EMH has been the dominant theory. The strictest version of the EMH states that it is not possible to "beat the market" because companies always trade at their fair value, making it impossible to buy undervalued stocks or sell them at exaggerated prices.

Behavioral finance emerged later to challenge this notion, pointing out that investors were not always rational and stocks did not always trade at their fair value during financial bubbles, crashes, and crises. Economists in this field attempt to explain stock market anomalies through psychology-based theories.

The AMH considers both these conflicting views as a means of explaining investor and market behavior. It contends that rationality and irrationality coexist, applying the principles of evolution and behavior to financial interactions.

How the Adaptive Market Hypothesis (AMH) Works

Lo, the theory’s founder, believes that people are mainly rational, but sometimes can quickly become irrational in response to heightened market volatility. This can open up buying opportunities. He postulates that investor behaviors — such as loss aversion, overconfidence, and overreaction — are consistent with evolutionary models of human behavior, which include actions such as competition, adaptation, and natural selection.

People, he added, often learn from their mistakes and make predictions about the future based on past experiences. Lo's theory states that humans make best guesses based on trial and error. This means that, if an investor's strategy fails, they are likely to take a different approach the next time. Alternatively, if the strategy succeeds, the investor is likely to try it again.

The AMH is based on the following basic tenets:

1. People are motivated by their own self-interests
2. They naturally make mistakes
3. They adapt and learn from these mistakes

The AMH argues that investors are mostly, but not perfectly, rational. They engage in satisficing behavior rather than maximizing behavior, and develop heuristics for market behavior based on a kind of natural selection mechanism in markets (profit and loss). This leads markets to behave mostly rationally, similar to the EMH, under conditions where those heuristics apply.

However, when major shifts or economic shocks happen, the evolutionary environment of the market changes; those heuristics that were adaptive can become maladaptive. This means that under periods of rapid change, stress, or abnormal conditions, the EMH may not hold.

Examples of the Adaptive Market Hypothesis (AMH)

Suppose there is an investor buying near the top of a bubble because they had first developed portfolio management skills during an extended bull market. While the reasons for doing this might appear compelling, it might not be the best strategy to execute in that particular environment.

During the housing bubble, people leveraged up and purchased assets, assuming that price mean reversion wasn't a possibility (simply because it hadn't occurred recently). Eventually, the cycle turned, the bubble burst and prices fell.

Adjusting expectations of future behavior based on recent past behavior is said to be a typical flaw of investors.

Criticism of Adaptive Market Hypothesis (AMH)

Academics have been skeptical about AMH, complaining about its lack of mathematical models. The AMH effectively just echoes the earlier theory of adaptive expectations in macroeconomics, which fell out of favor during the 1970s, as market participants were observed to most form rational expectations. The AMH is essentially a step back from rational expectations theory, based on the insights gained from behavioral economics.