Understanding Adaptive Market Hypothesis (AMH): Principles, Examples, and Critiques

The adaptive market hypothesis (AMH) introduces a blend of efficient market hypothesis (EMH) and behavioral finance, challenging the traditional stance on market rationality. MIT professor Andrew Lo, its founder, presents AMH as a means to reconcile the apparent contradiction between market efficiency and irrational behavior.

AMH serves as a bridge between EMH, which posits market rationality, and behavioral economics, emphasizing irrational behavior. In contrast to the strict EMH claiming markets are always rational, AMH acknowledges instances of irrationality during market extremes. It proposes a coexistence of rational and irrational behaviors, shaped by evolutionary principles and human adaptation.

Lo’s belief in human rationality forms the foundation of AMH, with a recognition that irrationality can surface during heightened market volatility. Behavioral biases such as loss aversion and overreaction align with evolutionary models of human behavior. AMH contends that individuals learn from mistakes, adapting and refining their strategies based on past experiences. It asserts that investors, while generally rational, engage in satisficing behavior, developing heuristics influenced by a natural selection mechanism in markets.

1. Self-interest motivation: Individuals act in their own self-interest.
2. Inherent mistakes: A natural inclination towards making mistakes.
3. Adaptation and learning: Individuals adapt and learn from these mistakes.

AMH argues that investors are mostly, but not perfectly, rational. They engage in satisficing behavior rather than maximizing behavior, developing heuristics for market behavior based on a natural selection mechanism in markets (profit and loss). This leads markets to behave mostly rationally, similar to the EMH, under conditions where those heuristics apply.

Under normal conditions, AMH aligns with the EMH, assuming rational behavior. However, during major shifts or economic shocks, the evolutionary environment of the market changes, rendering previously adaptive heuristics maladaptive. This implies that under periods of rapid change, stress, or abnormal conditions, the EMH may not accurately reflect market behavior.

An investor buying near the top of a bubble due to prior success during a bull market exemplifies how past behavior can influence future decisions. AMH emphasizes that adjusting expectations based on recent past behavior is a common investor flaw.

Despite its insights, AMH faces criticism for lacking mathematical models. Some academics view it as echoing earlier theories without significant advancements. It has been argued that AMH represents a step back from the rational expectations theory based on insights gained from behavioral economics.

AMH combines EMH principles with behavioral finance, acknowledging both rational and irrational market behaviors influenced by evolutionary principles.

AMH has been criticized for not providing mathematical models, a concern raised by academics questioning its rigor and applicability.

Under major shifts or economic shocks, AMH argues that the evolutionary environment of the market changes, impacting the adaptability of previously effective heuristics.