What Is the Adaptive Expectations Hypothesis?

Adaptive expectations hypothesis is an economic 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.

Key Takeaways

  • The adaptive expectations hypothesis proposes that people update their prior beliefs about future probabilities based on new information from the recent past.
  • In finance, investors will therefore tend to believe that trends will extend into the future, perhaps erroneously.
  • This theory can help explain the rise of bubbles and crashes arising from exuberance or dismay based on recent market movements.

Understanding the 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 and focus instead on recent activity and the expectation that it will continue. In reality, 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.

This hypothesis, where prior beliefs are updated as new information arrives is an example of Bayesian updating. However, in this case the belief that trends will persist because they have occurred can lead to overconfidence that the trend will continue indefinitely—which can lead to asset bubbles.

Examples of the 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.