Academic Insights on Investing

Weekly Academic Insight: Adaptive Markets Hypothesis


Authors: A. LO
Link: Adaptive Markets

#What is the Research Question?:

1) Can rationality (modern financial theory) and irrationality(behavioral economics) co-exist in investment management?

#What are the Academic Insights?:

Drawing on psychology, evolutionary biology, neuroscience, artificial intelligence, and other fields, the author shows that the theory of market efficiency isn’t wrong but merely incomplete. As an alternative, the author proposes the Adaptive Markets Hypothesis, “which is based on the insight that investors and financial markets behave more like biology than physics, comprising a population of living organisms competing to survive, not a collection of inanimate objects subject to immutable laws of motion.”

This theory implies that 1) market prices need not always reflect all available information, but can deviate from rational pricing relations from time to time because of strong emotional reactions like fear and greed. Additionally, it implies that 2) market risk isn’t always rewarded by market returns, 3) investing in stocks, in the long run, may not always be a good idea, especially if your savings can be wiped out in the short run, 4) changing business conditions and adaptive responses are often more important drivers of investor behavior and market dynamics than enlightened self-interest.

#Why does it Matter?:

This book is a new way of thinking about financial markets and human behavior. After the great financial crisis of 2008, there has been a fundamental change in the behavior of financial markets: from the “wisdom of crowds” to the “madness of mobs.” According to the author, this Jekyll- and- Hyde personality of financial markets, oscillating between wisdom and madness, isn’t a pathology but simply a reflection of human nature. For the past fifty years, academic finance has been dominated by highly mathematical models and methods that have much more in common with physics than biology. Richard Feynman, speaking at a Caltech graduation ceremony, once said, “Imagine how much harder physics would be if electrons had feelings.” However, the author recommends that we start switching gears in our financial thinking…because the financial crises showed us that investors, portfolio managers, and regulators do have feelings!