DEFINITION of 'Adaptive Expectations Hypothesis'

Adaptive expectations hypothesis is a theory that states individuals adjust their expectations of the future based on recent past experiences and events. In finance, this effect can cause people to make investment decisions based on the direction of recent historical data, such as stock price activity or inflation rates, and adjust the data (based on their expectations) to predict future activity or rates.

BREAKING DOWN 'Adaptive Expectations Hypothesis'

Adaptive expectations hypothesis suggests that investors will adjust their expectations of future behavior based on recent past behavior. If the market has been trending downward, people will likely expect it to continue to trend that way because that is what it has been doing in the recent past. The tendency to think this way can be harmful as it can cause people to lose sight of the larger, long-term trend the focus instead on recent activity and the expectation that it will continue. In actuality, many items are mean reverting. If a person becomes too focused on recent activity they may not catch signs of the turning point and can miss out on opportunity.

Examples of Adaptive Expectations Hypothesis

For example, before the housing bubble burst, home prices had been appreciating and trending upward for a considerable length of time in many geographic areas of the U.S. People focused on this fact and assumed it would continue indefinitely, so they leveraged up and purchased assets with the assumption that price mean reversion wasn't a possibility because it hadn't occurred recently. The cycle turned and prices fell as the bubble burst.

As another example, if inflation over the last 10 years has been running in the 2-3% range, investors would use an inflation expectation of that range when making investment decisions. Consequently, if a temporary extreme fluctuation in inflation occurred recently, such as a cost-push inflation phenomenon, investors will overestimate the movement of inflation rates in the future. The opposite would occur in a demand-pull inflationary environment.

  1. Hypothesis Testing

    A process by which an analyst tests a statistical hypothesis. ...
  2. Permanent Income Hypothesis

    The Permanent Income Hypothesis is a theory of consumer spending ...
  3. Type II Error

    A type II error is a statistical term used within the context ...
  4. Life-Cycle Hypothesis (LCH)

    The Life-Cycle Hypothesis (LCH) is an economic theory that pertains ...
  5. Adaptive Selling

    Adaptive selling is a tailored client centric approach to selling, ...
  6. Bernoulli's Hypothesis

    Bernoulli's hypothesis states a person accepts risk not only ...
Related Articles
  1. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  2. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  3. Insights

    Inflation's Impact on Stock Returns

    Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
  4. Insights

    Cost-push inflation versus demand-pull inflation

    Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
  5. Insights

    Investopedia Explains Fractal Markets Theory

    Fractal Market Hypothesis has emerged as an alternative to longstanding economic theories due to its ability to explain investor behavior during crises.
  1. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  2. How Does an Efficient Market Affect Investors?

    The efficient market hypothesis refers to aggregated decisions of many market participants. Read Answer >>
  3. What is the Efficient Market Hypothesis?

    Find out about the key assumptions behind the efficient market hypothesis (EMH), its implications for investing and whether ... Read Answer >>
  4. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
  5. Why Are P/E Ratios Higher When Inflation Is Low?

    P/E ratios are generally higher during times of low inflation, but why is this the case? Read Answer >>
Trading Center