Adaptive Market Hypothesis

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.

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.

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: People are motivated by their own self-interests, they naturally make mistakes and they adapt and learn from these mistakes.

The AMH argues that investors are mostly, but not perfectly, rational.

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