The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective

Motivation(s)

Efficient Markets Hypothesis (EMH) is one of the most enduring ideas of modern finance. EMH asserts that in an informationally efficient market, price changes must be unforecastable if they fully incorporate the information and expectations of all market participants. The theory has been extended to incorporate non-traded assets (e.g. transaction cost, human capital), but the overall idea still revolves around prices, probabilities, and preferences:

  • Individual investors form expectations rationally.

  • Markets aggregate information efficiently.

  • Equilibrium prices incorporate all available information.

The standard approach to modeling preferences is to assert that investors optimize additive time-separable expected utility functions from certain parametric families. This has been criticized by psychologists and behavioral economists for ignoring behavioral biases that are endemic in decision-making under uncertainty (e.g. overconfidence, overreaction, loss aversion, herding, psychological accounting, miscalibration of probabilities, hyperbolic discounting, regret). Furthermore, there needs to be some degree of market inefficiency (e.g. noise traders); otherwise, there is no profit to gathering and trading on information.

Proponents of EMH argue that there are limits to the degree and persistence of behavioral biases, and arbitrageurs will take advantage of these opportunities until they no longer exist (i.e. Dutch book); hence the market prices will become rational again. Their conclusion implicitly assumes rational beliefs are not so pervasive as to overwhelm the capacity of arbitrage capital, however, empirical results (e.g. LTCM) have illustrated contrarily.

More recently, economists and biologists have begun to explore the connections between sociobiology and economics. One of the more recognized idea was bounded rationality and satisficing: individuals are bounded in their degree of rationality and make choices that are merely satisfactory. Unfortunately, this idea was dismissed because it did not offer a way to determine the point at which an individual stops optimizing and reaches a satisfactory solution.

Proposed Solution(s)

The author proposes the Adaptive Markets Hypothesis (AMH), an extension of bounded rationality and satisficing that includes evolutionary principles (e.g. natural selection). The AMH asserts that behavioral biases are actually maladaptive suboptimal behaviors. Individuals make choices based on past experience and their best guess as to what might be optimal; they learn by receiving positive or negative reinforcement from the outcomes in some environment. When the environment changes, the previously developed heuristics may become unsuitable for survival.

Through the lens of evolutionary biology, many other aspects of economic behavior (e.g. competition, cooperation, market-making behavior, general equilibrium, disequilibrium dynamics) can be derived in a way that is consistent with established neuroeconomics research.

Evaluation(s)

This is a theoretical paper that uses a limited number of economics examples to illustrate how evolutionary biology can be used to model investors. The author admits more solid evidence are needed in order to arrive at a quantitative framework.

Future Direction(s)

  • What is an appropriate generative process to model trading firms (e.g. Goldman Sachs)?

Question(s)

  • Evolutionary principles are qualitative, so how would one transform it into a quantitative metric (e.g. Price equation)?

Analysis

The AMH is more reflective of how the market functions than EMH. The theory’s usage of evolutionary principles nicely captures the market’s arbitrariness. Unfortunately, the author has not yet worked out a quantative framework that one can apply immediately. One of the more interesting points is how economists easily dismiss a more natural description of decision making just to stay within the norm.

References

Lo04

Andrew W Lo. The adaptive markets hypothesis: market efficiency from an evolutionary perspective. Journal of Portfolio Management, Forthcoming, 2004.