What Is Adaptive Market Hypothesis (AMH)?

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.

Key Takeaways

  • The adaptive market hypothesis (AMH) combines principles of the well-known and often controversial efficient market hypothesis (EMH) with behavioral finance
  • Andrew Lo, the theory’s founder, believes that people are mainly rational, but sometimes can overreact during periods of heightened market volatility.
  • AMH argues that people are motivated by their own self-interests, make mistakes, and tend to adapt and learn from them.

Understanding Adaptive Market Hypothesis (AMH)

Adaptive market hypothesis (AMH) attempts to marry the theory posited by EMH that investors are rational and efficient with the argument made by behavioral economists that they are actually irrational and inefficient.

For years, EMH has been the dominant theory. It 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.

Adaptive market hypothesis (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.

How Adaptive Market Hypothesis (AMH) Works

Lo, the theory’s founder, believes that people are mainly rational, but sometimes can quickly become irrational in response to heightened market volatility, opening 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.

That means that if an investor's strategy fails, he or she is likely to take a different approach the next time. Alternatively, if the strategy succeeds, the investor is likely to try it again.

The adaptive market hypothesis (AMH) is based on the following basic tenets:

  1. People are motivated by their own self-interests
  2. They naturally make mistakes
  3. They adapt and learn from these mistakes

Example of Adaptive Market Hypothesis (AMH)

Lo provided a handful of historical examples showing when his adaptive market hypothesis (AMH) can be applied.

One of them referred to an investor buying near the top of a bubble because he or she first developed portfolio management skills during an extended bull market. Lo described this as “maladaptive behavior”, arguing that the reasons for doing this might appear compelling, even if it is not the best strategy to execute in that particular environment.

During the housing bubble, people leveraged up and purchased assets, assuming that price mean reversion wasn't a possibility because it hadn't occurred recently. Eventually, the cycle turned, the bubble burst and prices fell.

Adjusting expectations of future behavior based on recent past behavior is said to be a typical flaw of investors.

Criticism of Adaptive Market Hypothesis (AMH)

Many in the industry applauded Lo’s theory, agreeing that adaption is key to survival. However, academics have been more skeptical, complaining about its lack of mathematical models.