What is Adaptive Market Hypothesis?
AMH as presented by Professor Andrew Lo at MIT Sloan, suggests a unifying theory between the EMH and the more recent wave that is behavioral economics. Instead of the mathematical and almost physics like rigidness of EMH, as well as the psychological interpretations of financial economics, AMH takes a new approach, a biological approach. In his book Adaptive Market Hypothesis, Professor Andrew Lo suggests that market behavior does not have to be one or the other. Instead, he rides on the logic that prices in financial markets are a result of humans and that human interactions as a system should be the basis of understanding the prices.
Not all humans are going to be as critical, rational and predictable as the purest EMH supporter may suggest, while not all investors are going to be as gullible and susceptible to systemic psychological errors as the purest of all behavioralist may suggest either. Instead, the ecosystem that creates these interactions which gives market pricing equilibrium is really an environment that contains both rational and less rational individuals. Furthermore, almost most important of all, people learn. Through AMH, Professor Andrew Lo introduces a new assumption. The assumption of change and learned behavior over time. This implies that there exists both times where the markets are more efficient, and times where perhaps irrational exuberance does exist. And the back and forth between both times is due to a myriad of complex factors affecting one another. Additionally, factors like new innovative technology that allows for more efficient information flow, or heightened irrationality from extraneous unforeseen circumstances can play a role in influencing the efficiency of the market in those periods.
In other words, knowing the complexity of the markets with the various players at play, it may seem naïve to think that the market is completely rational or completely irrational. Markets are made up of humans and humans are complicated. We are in a constant cycle of learning, trying, and adapting. Shouldn’t markets be the same?
Lo, A. W. (2004). The adaptive markets hypothesis. The Journal of Portfolio Management, 30(5), 15-29.
Lo, A. W. (2017). Adaptive markets. In Adaptive Markets. Princeton University Press.
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