Adaptive Markets Hypothesis (AMH) As an Alternative to the Efficient Market Hypothesis (EMH)

Efficient market hypothesis was introduced by French mathematician Louis Bachelier in 1900 in his dissertation. Efficient Market Hypothesis says that markets are completely efficient and that all prices in the market already reflect the available knowledge and expectations of investors.

This concept of market efficiency has a wonderfully counterintuitive and seemingly contradictory flavor to it: The more efficient the market, the more random the sequence of price changes generated by such a market must be, and the most efficient market of all is one which price changes are completely random and unpredictable. This is a direct outcome of many active traders using the smallest informational advantages at their disposal and attempting to profit from their information. This quickly eliminates the profit opportunities that give rise to their actions.

If we assume an idealized world of "frictionless" markets and costless trading, then prices must always fully reflect all available information and no profits can be garnered from information-based trading because such profits have already been captured.

The Efficient Market Hypothesis (EMH) is particularly relevant to the Alternative Investments Industry because the primary attraction of Alternative Investments Products is their higher expected returns and, in many cases, lower risk as measured by correlation to broad-based market index such as the S & P 500 and the Dow Jones.

If the Efficient Market Hypothesis (EMH) is true, it should not be possible to generate higher expected returns after adjusting for risk.

Let us look at the Capital Asset Pricing Model (CAPM).

According to this model the risk-adjusted expected return of any investment "p" is determined by the market beta of that investment:

E[RP]= RF + ß(E[Rm]- RF),

If we transposed for ß in percentage, we get:

ß = {E [RP] - RF)}/ {E [RM]-RF} X100

Where:

RF = the return on a risk free asset such as 10 Year U.S Treasury Bills

E [RM] = is the expected return on the market portfolio which is normally approximated by the S& P 500.

If we test a sample of data of say 10 different alternative investments products you will find that a number of them exhibit excess expected returns, which implies that the models are wrong or that the markets are inefficient.

MIT finance professor Andrew Lo is turning heads by developing a new theory about the way that markets behave called the Adaptive Markets Hypothesis (AMH). His resulting Adaptive Markets Hypothesis (AMH) explains the apparent irrationality of markets as a rational reaction to a change in environmental conditions.

I do believe in the adaptive markets hypothesis as an alternative to the Efficient Market Hypothesis (EMH). It is a better model.

The Adaptive Markets Hypothesis (AMH) is based on principles of evolutionary biology such as competition, mutation, reproduction, and natural selection.

It is a theory that expectations about market conditions are based in somewhat imperfect perceptions of how recent events might affect the future, and with less than perfect rationality.

Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management. Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants. According to Andrew W. Lo, the Adaptive Markets Hypothesis can be viewed as a new version of the efficient market hypothesis, derived from evolutionary principles.

The AMH paradigm views markets as ecological systems in which different groups or "species" compete for scarce resources. The system will tend to exhibit cycles in which competition depletes existing resources (trading opportunities), but new opportunities then appear.

Under the Adaptive Markets Hypothesis (AMH) investment strategies will under go cycles of profitability and loss in response to changing business conditions, the number of competitors entering and exiting the industry, and the type and magnitude of profit opportunities available. As opportunities shift, the affected populations will also shift.

The AMH has a number of concrete implications for the alternative investment industry. The first implication is that contrary to the classical EMH, arbitrage opportunities do exist from time to time in the AMH, for without such opportunities there would be no incentive to gather information, and price discovery aspect of financial markets would collapse.

As long as there is an active liquid financial markets there will be profit opportunities. However as traders exploit them, they will disappear. I believed that new opportunities are continually being created as traders die out, as others are born, and as institutions and business conditions change.

In the past decades, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows and will continue to do so.

The Adaptive Markets Hypothesis (AMH) is a much better model. Rather than the inexorable trend towards higher efficiency predicted by the EMH, the AMH implies considerably more complex market dynamics, with cycles as well as trends, panics, manias, bubbles, crashes, and other phenomena routinely witnessed in natural market ecologies

The second implication is that trading strategies also wax and wine, performing well under certain market conditions and performing poorly in order market conditions

The third implication is that innovation is the key to survival

Finally, the AMH has a clear implication for all financial market participants:

Survival is the only objective that matters. While profit maximization, utility maximization, and general equilibrium are certainly relevant aspects of the market ecology, the organizing principle in determining the evolution of markets and financial technology is simply survival

Let us now look at three prediction of the AMH:

Profit opportunities will generally exist in financial markets.

The forces of learning and competition will gradually erode these profit opportunities

More complex strategies will persist longer than simple ones.

According to Wikipedia:

The AMH has several implications that differentiate it from the EMH such as:

1. To the extent that a relation between risk and reward exists, it is unlikely to be stable over time.
2. Contrary to the classical EMH, arbitrage opportunities do exist from time to time.
3. Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. This includes quantitatively-, fundamentally- and technically-based methods.
4. Survival is the only objective that matters while profit and utility maximization are secondary relevant aspects
5. Innovation is the key to survival because as risk/reward relation varies through time, the better way of achieving a consistent level of expected returns is to adapt to changing market conditions.