DEFINITION of 'Adaptive Market Hypothesis'

The adaptive market hypothesis is a theory posited in 2004 by MIT professor Andrew Lo. It combines principles of the well-known and often controversial Efficient Market Hypothesis with principles of behavioral finance. Behavioral finance was developed in response to the observation that people are not completely rational actors as assumed by many economic and market theories. Lo 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.

BREAKING DOWN 'Adaptive Market Hypothesis'

Adaptive market hypothesis attempts to marry the rational, efficient market hypothesis principles with the irrational behavioral finance principles. The theory states that humans make best guesses based on trial and error. For example, if an investor's strategy fails, he or she is likely to try a different strategy. If the strategy is successful, however, the investor is likely to try it again.

Adaptive market hypothesis applies the principles of evolution and behavior to financial interactions. Efficient market hypothesis states that it is not possible to "beat the market" because stocks always trade at their fair value, making it impossible to buy undervalued stocks or sell stocks for exaggerated prices. Behavioral finance attempts to explain stock market anomalies through psychology-based theories. Adaptive market hypothesis considers both as a means of explaining investor and market behavior.

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