Adaptive-market theory offers investor insights

Feb 7, 2005 @ 12:01 am

By Mike Clowes

The key implication of the efficient-market hypothesis, the dominant market theory of the past two decades, is that it is impossible for investors consistently to beat the return of the stock market on a risk-adjusted basis.

That is, active management of stock portfolios is a waste of money, time and effort.

The hypothesis says that market prices for stocks incorporate all relevant information about companies instantaneously.

In addition, the efficient-market hypothesis assumes that investors act rationally and attempt to maximize the expected utility of their risk-and-return decisions.

But if investors act rationally, why do so many still seek active-management returns?

Recent studies in behavioral finance - studies of how people make decisions involving money - show that in fact, investors are "often - if not always - irrational, exhibiting predictable and financially ruinous behavior," according to Andrew Lo, a brilliant young finance professor at the Massachusetts Institute of Technology in Cambridge.

Mr. Lo has proposed a different hypothesis, which incorporates the insights offered by behavioral finance into capital markets theory.

In effect, his hypothesis, which he calls the adaptive-market hypothesis, attempts to reconcile the concepts underlying the efficient-market hypothesis with behavioral-finance revelations about the way people behave.

Mr. Lo's hypothesis assumes that individuals make choices that are merely satisfactory, not necessarily optimal. That is, they are "satisficers," not "optimizers." That's because "optimization is costly, and humans are naturally limited in their computational abilities."

Mr. Lo's paper, "The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective," published in August 2004 and available on his website,, pointed to many behavioral-finance papers that have called into question the rational optimizing behavior of investors that is key to market efficiency.

'Behavioral biases'

He argued that individuals make choices based on past experience and their "best guess" as to what might be satisfactory for them. They use shortcuts based on experience to make decisions on the various economic challenges they face. As long as the challenges remain stable, these shortcuts will eventually adapt to yield approximately optimal solutions,

If the environment changes, however, the old decision rules may no longer work. They appear to be "behavioral biases."

Mr. Lo's adaptive-markets hypothesis says prices reflect as much information as dictated by the combination of environmental conditions (i.e., market conditions) and the number and nature of distinct groups of market participants, each behaving in a common manner. For example, he wrote, pension funds, retail investors, market makers and hedge funds all may be considered distinct groups.

If many of these groups compete for rather scarce resources (e.g., alpha, or economic profits) within a single market, the market is likely to be highly efficient. If a small number of groups compete for abundant resources, the market will be less efficient.

Under his hypothesis, because people use shortcuts to help in decision making, behavioral biases abound.

The effect of these biases on the market is determined by the size of the group with a bias, relative to the sizes of groups using more-effective decision models. That is, any relationship between risk and reward is unlikely to be stable and is determined by the relative sizes and preferences of the various populations in the market.

As an example, Mr. Lo pointed out that in late 1998, in the wake of the Russian government's default on its debt, many bond investors desired liquidity and safety, overwhelming the population of hedge funds attempting to take advantage of that desire, causing historic relationships to break down. Ultimately, this breakdown led to the collapse of Long-Term Capital Management LP of Greenwich, Conn.

Also under Mr. Lo's hypothesis, aggregate-risk preferences are not fixed but are shaped by forces of natural selection - as lack of success forces some groups of investors out of the market to be replaced by new groups with little or different experience.

Under his hypothesis, contrary to the efficient-market hypothesis, arbitrage opportunities exist from time to time. Also, investment strategies will wax as more and more investors adopt an apparently successful strategy. This will drive down the returns on the strategy, causing it to be unsuccessful and fall out of favor for a time, until returns grow again.

Perhaps the most important implication of Mr. Lo's adaptive-market hypothesis is: "Innovation is the key to survival." The efficient-market hypothesis assumes that a desired level of expected return can be achieved simply by bearing a sufficient level of risk.

Mr. Lo's hypothesis implies that the risk-reward relationship varies through time and that the way to achieve "a consistent level of expected returns is to adapt to changing market conditions."

His hypothesis explains why so many investors continue to seek excess risk-adjusted returns from active management, which the efficient-market theory says is impossible.

Note, however, that Mr. Lo's hypothesis doesn't say finding such returns is easy.


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