AMH - Adaptive Markets Hypothesis

The Adaptive Markets HypothesisMichael ChanJohn HautzingerConstance JiangIntroductionEfficient Markets Hypothesis (EMH)Propose new framework, Adaptive Markets Hypothesis (AMH), reconciling EMH with behavioral biasesEfficient 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 warrantedExperiments 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 alternativeLinda is a bank tellerLinda 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% probabilityExperiments behavioral bias(contd)A&D equivalent to:25% chance of $240k yield, 75% chance of $760k lossB&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 lossesAMH - Adaptive Markets Hypothesis

Uses a Darwinian perspectivefinancial markets = ecosystem dealers = herbivoresspeculators = carnivoresfloor traders and distressed investors = decomposersAdaptive Markets HypothesisSatsificing 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 waterAdaptive 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 equilibriumCompetition increaseResource depletedDecline in populationLess competitionSometimes permanent loss of resource or extinction of speciesRole of the ConsultantAssists managers and investors in dealing with preferences.Educate investors and managersAssist in examine/modifying risk preferencesMatching investor and manager's perferencesRole 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 programsApplicationsProblemsStill in its infancyMuch research must be done to establish viabilityHowever, 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 pitfallsPitfalls must first be known in order to avoid themEach 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 preferencesAdvances in Studying Decision MakingNueroscienceDecisions are interactions between specialized parts of the brainUse of a combination of survey techniques must be used to achieve desired resultsWork 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 frameworkSelection of portfolio weights for broad asset classesRelation between risk and rewardNever stable over timeInsights from AMHAggregate risk preferences are constantly being shaped and reshaped over timeNatural selection processContrary 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 outInsights 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 returnExample: Risk ArbitrageBecame unprofitable in the decline of 2001As pace mergers and acquisitions increase, risk arbitrage will come back to profitabilityInsights 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 favorableBottom 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 directionsDynamics 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 conditionsFor ConsiderationAsk where the next financial asteroid will come fromThe AMH has a clear implication for all financial market participantsSurvival is ultimately the only objective that mattersProfit maximization, utility maximization, and general equilibrium are certainly relevant aspects of market ecologyThe organizing principle in determining the evolution of markets and financial technology is simply survival.InnovationKey to AMH FrameworkTakes on an urgency generally missing from most financial decision making paradigmsEMHModern portfolio theoryCapital 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 termML allows for consideration of all aspects of the decision process