Michael Chan John Hautzinger Constance Jiang. Introduction Efficient Markets Hypothesis (EMH) Propose new framework, Adaptive Markets Hypothesis (AMH),

The Adaptive Markets Hypothesis

Michael ChanJohn HautzingerConstance Jiang

IntroductionEfficient Markets Hypothesis (EMH)Propose new framework, Adaptive Markets

Hypothesis (AMH), reconciling EMH with behavioral biases

Efficient Markets HypothesisThe notion that markets fully, accurately, and

instantaneously incorporate all available information into market pricesParticipants are rational beings always making

optimal choices in self-interestPsychologists and experimental economists

have documented behavioral biases that do not follow market rationalityEMH criticizes behavior as observations

without principles to explain the origin

Experiments - overconfidenceRusso & Shoemaker (1989) – subjects asked

to give 90% confidence answers(ranges) in response to questions w/numerical answersSubjects should be wrong only 10% of the timeResults: < 1% of the subjects scored 9/10.

Most missed 4-7 questions.Most individuals are more confident of their

knowledge than is warranted

Experiments – reliance on representativesTversky and Kahneman (1982) proposed a

question to subjects and asked them to pick the more likely answerLinda is 31 years old, single, outspoken, and

very bright. She majored in philosophy. As a student, she was deeply concerned w/ issues of discrimination & social justice, & participated in anti-nuclear demonstrations. Check the more likely alternative Linda is a bank teller Linda is a bank teller and is active in the feminist

movement.

Experiments – behavioral biasKahneman & Tversky (1979) - 2 investment

opportunities, A & B:A yields sure profit of $240kB yields $1mil w/25% probability & $0 w/75%

probabilityC & D:

C yields sure loss of $750kD yields $0 w/25% probability & $1mil loss

w/75% probability

Experiments – behavioral bias(contd)A&D equivalent to:

25% chance of $240k yield, 75% chance of $760k loss

B&C equivalent to:25% chance of $250k yield, 75% chance of

$750k lossB&C has $10k higher gain, $10k lower loss

Neuroscience PerspectiveParts of the brain: brain stem, limbic system,

cerebral cortexPhysiological adaptations geared towards

survivalHumans adapt to fit environmental conditions

[Investment] preferences may change as wellCompetitiveness of global financial markets

suggests Darwinian selection is also applicableUnsuccessful market participants are eliminated

after suffering certain losses

AMH - Adaptive Markets Hypothesis

Uses a Darwinian perspectivefinancial markets = ecosystem dealers = herbivoresspeculators = carnivoresfloor traders and distressed investors =

decomposers

Adaptive Markets Hypothesis“Satsificing“

Due to limited computational abilitiesMaking choices to meet satisfactory standards.

How to determine what's satisfactory? Pos/Neg reinforcement leads to learning.When economic challenges stabilize, there's your

optimal solution.

Change of environmentBecome "maladaptive," fish out of water

Adaptive Markets HypothesisAMH - the new EMH

(A1) Individuals act in their own self-interest.(A2) Individuals make mistakes.(A3) Individuals learn and adapt.(A4) Competition drives adaptation and

innovation.(A5) Natural selection shapes market ecology.(A6) Evolution determines market dynamics.

Adaptive Markets HypothesisEverything converges to equilibrium

Competition increaseResource depletedDecline in populationLess competitionSometimes permanent loss of resource or

extinction of species

Role of the ConsultantAssists managers and investors in dealing with

preferences.1. Educate investors and managers2. Assist in examine/modifying risk preferences3. Matching investor and manager's

perferences

Role of the ConsultantSensitive to changing markets.

Familiar with a wide spectrum of investment products and services

Must continually seek education.Financial technologyAdvances in neuroscienceTraining and certification programs

ApplicationsProblemsStill in its infancy

Much research must be done to establish viability

However, questions arise about the relevancy of AMH compared to previously established EMHA wealth of tools exist for EMHEMHs have a long history

Preferences MatterIndividual preferences have long been

studied in a variety of pitfallsCare must be taken to avoid pitfalls

Pitfalls must first be known in order to avoid them

Each industry focuses on a different aspect of decision makingPsychological surveys are designed to capture

broad characteristics of personalityEconomists perform choice experimentsMarket Researchers conduct field studies of

consumer preferences

Advances in Studying Decision MakingNueroscience

Decisions are interactions between specialized parts of the brain

Use of a combination of survey techniques must be used to achieve desired results

Work must be done with investors on an individual basisIn order to help articulate and accurately

represent the final goals of the individual

Revisiting Asset AllocationAnother facet of the AMH framework

Selection of portfolio weights for broad asset classes

Relation between risk and rewardNever stable over time

Insights from AMHAggregate risk preferences are constantly

being shaped and reshaped over timeNatural selection process

Contrary to EMH arbitrage do exist from time to timeAs profit opportunities come to light, they are

exploited and disappearNew opportunities appear as older

opportunities die out

Insights from AMH(Cont.)Like profit opportunities, investment

strategies wax and waneUnlike EMH in which opportunities are

competed away, AMH allows for the assumption that opportunities may decline, but will return

Example: Risk Arbitrage Became unprofitable in the decline of 2001 As pace mergers and acquisitions increase, risk

arbitrage will come back to profitability

Insights from AMH(Cont.)Value and growth may behave like risk

factors from time to timePortfolios with such characteristics may yield

higher returns than periods when those factors are favorable

Bottom Line Regarding Active Asset Allocation Policies may only be right for certain people

under certain market conditionsAMH does not imply active asset allocation is

any less difficultProvides a rationale for the apparent cyclical

nature of risk factors and points the way to promising new research directions

Dynamics of Competition and Market EcologyAnother key application of the AMH

framework to investment management is the insight that innovation is the key to survivalEMH suggests that certain levels of expected

returns can be achieved simply by bearing a sufficient degree of risk.

AMH implies that the risk/reward relation varies through time and that a better way of achieving a consistent level of expected returns is to adapt to changing market conditions

For ConsiderationAsk where the next financial asteroid will

come fromThe AMH has a clear implication for all

financial market participants Survival is ultimately the only objective that matters Profit maximization, utility maximization, and

general equilibrium are certainly relevant aspects of market ecology

The organizing principle in determining the evolution of markets and financial technology is simply survival.

InnovationKey to AMH Framework

Takes on an urgency generally missing from most financial decision making paradigms EMH Modern portfolio theory Capital Asset Pricing Model (CAPM)

Role of Adaptive Markets in Machine LearningAdaptive markets imply an every changing,

however somewhat cyclical marketplacePerfect for machine learningIf truly cyclical then machine learning could

use known parameters to predict outcomes in the short and long term

ML allows for consideration of all aspects of the decision process