Adaptive Markets Hypothesis: Practical Implications

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Table of Contents

Introduction
Analysis and Discussion
Conclusion
References

Introduction

This paper seeks to discuss the statement that investors, according to Adaptive Market Hypothesis (AMH), are not necessarily irrational when they are just applying their old heuristics to new market conditions. The discussion will be accomplished with particular reference to Lo’s “Practical Implications” from AMH.

Analysis and Discussion

What is AMH?

The AMH is a theory proposed by Lo (2004) as a way to reconcile the seeming deficiencies of the Efficient Market Hypothesis and behavioural finance. In arriving at the concept, Lo (2004) factored in the dynamics of evolution, natural selection and other related factors which determine the efficiency of markets and the increasing and decreasing financial institutions together with their investment products, and even institutional and individual affluence at the end of the day.

What are the practical implications of AMH from Lo (2004)? Do they deny or confirm the rationality or lack of it by the investor?

First implication

Lo (2004) gave several practical implications of AMH. The first implication, according to Lo (2004), is the extent of the relationship between risk and reward, which he asserts to be unlikely stable over time. In effect, Lo (2004) admits of the relationship of risk and return and which is still a sign of rationality of the investors but asserts that the relationship will not be stable over time as he relates the same with different factors such as the relative sizes and various population of market ecology including the institutional aspects such as regulatory environment and tax laws. He explained that there would be changes with factors; thus, changes in risk/reward relation must also change (Lo, 2004).

There is the basis to agree with Lo as it could be, in fact, shown that different sizes and populations of investors do not necessarily have the same reactions to similar situations and the different regulatory environments and tax laws have different stages of development that may cause different reactions from investors in making decisions.

Lo (2004) also asserted that as an upshot of the first implication, it could be further implied that the equity risk premium also varies with time and path. His argument sustaining the presence of rationality lies in the fact that the equity risk premium must vary in relation to changes in risk preferences over time (Lo, 2004). It is not difficult again to agree with Lo’s inference of consequence on the implication asserted since varying risk premium is a sign of periodic lack of stability in terms of risk/return relationships.

Lo (2004) further explained by asserting that the possible increases in the stock price are not always constantly happening but are affected by natural selection forces. To justify the position taken, he cited the recent case of US markets that were populated by a significant group of investors who have never experienced a genuine bear market.

He pointed out that this fact had undoubtedly shaped the aggregate risk preference of the US economy when compared with the experience of the last four years since the bursting of the technology bubble has affected the risk preference of the current population of investors (Lo, 2004)—using natural selection factor as one characteristic of AMH, Lo (2004) that asserted that the same factor determines who participates in market interactions to the effect that those who experienced considerable losses in the technology bubble are more likely to have gone out of the market and such phenomenon would have left a diverse group of investors more in recent times than almost half a decade ago.

He further explained that through the forces of natural selection, what happens in the past is relevant; thus, the paths that that market prices have taken over the past few years could determine the current aggregate risk preferences.

In this sense, it could still be deciphered that investors are still rational by further considering what happened in the past as the basis of their decisions in choosing investments.

Second implication

Lo (2004) cites a second implication which is contrary to EMH—that is, arbitrage opportunities do arise from time to time in the AMH. Arbitrage opportunities do provide incentives for investors to gather information in order to benefit from the seeming overvaluation or undervaluation of prices of investments in the market (Van Horne, 1992). He also asserted from an evolutionary perspective that the fact that financial markets are characterized as liquid could also mean the presence of profit opportunities (Lo, 2004).

Being motivated, therefore, by profit opportunities, is a sign of rational investors in that everybody wants to beat the market as much as possible, and by the belief that at certain times market prices of stocks are undervalued, the investors would likely buy stocks for the purpose of selling the same. On the other hand, if stocks are overvalued, they would most likely dispose of their stocks at the earliest possible time before the anticipated decline will ensue.

Third implication

AMH’s third implication is that investment strategies will sometimes increase and decrease in yield or profits and may do well in certain situations and not well in other situations (Lo, 2004). He explained that AMH implies that such investment strategies may fall for a time and then reclaim profitable positions during conducive times. He contrasted this position with the classical EMH in which arbitrage opportunities are driven away due to competition and thus will, in due course, eliminate the profitability of the strategy designed to exploit the arbitrage (Lo, 2004).

His argument is based on the relativity of time, which could have different meanings to different investors. Since investors believed incorrect timing of decision under this implication, it could be further asserted that there is still rationality by the use of some techniques to choose their investments.

Fourth Implication

The fourth implication of AMH, as cited by Lo (2004), is the assertion that innovation is the key to survival. He explained that the classic EMH proposes that a certain level of expected returns is attainable by bearing a sufficient degree of risk. In comparison, AMH proposes changing strategies to achieve a consistent level of expected profitability or returns by sellers due to risk/reward relations having to vary over time. A better way to achieve a consistent level of expected returns is to adapt to changing market conditions (Lo, 2004).

Again, an attribute of rationality is still consistent with AMH since there is an intention to achieve a consistent level of returns by adapting to certain conditions. A rational mind adapts precisely to changing environments.

Fifth implication

This implication is, in effect, the outcome of the earlier implications. It asserts that survival is the name of the game, and it is only the thing that matters (Lo, 2004). Because of changing conditions, investors need to adapt. Otherwise, they could be left losing money as a result of the struggle in fighting what will justify the risk of investments. Again, survival could be mean rationality.

Conclusion

There is the basis to agree with AMH that investors are not necessarily irrational and that they are just applying their old heuristics to new market conditions. AMH believes in changing market conditions which demand changing strategies for investors. Changing conditions change the level of returns, which must vary over time; hence strategies must also be changing accordingly. Since AMH has its roots in evolutionary concepts and natural selection, it goes without saying that those who deserve to survive are those that are most adaptable to changes. Adaptability is still rationality; thus, investors under AMH are still indeed very much rational.

References

Lo, A. (2004) The Adaptive Markets Hypothesis. Journal of Portfolio Management, Vol 30, pp.15-29.

Van Horne (1992) Financial Management Policy, Prentice-Hall, Inc., London, UK.

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