The Adaptive Markets Hypothesis

1. The Adaptive Markets Hypothesis Michael Chan John Hautzinger Constance Jiang

2. Introduction • Efficient Markets Hypothesis (EMH) • Propose new framework, Adaptive Markets Hypothesis (AMH), reconciling EMH with behavioral biases

3. Efficient Markets Hypothesis • The notion that markets fully, accurately, and instantaneously incorporate all available information into market prices • Participants are rational beings always making optimal choices in self-interest • Psychologists and experimental economists have documented behavioral biases that do not follow market rationality • EMH criticizes behavior as observations without principles to explain the origin

4. Experiments - overconfidence • Russo & Shoemaker (1989) – subjects asked to give 90% confidence answers(ranges) in response to questions w/numerical answers • Subjects should be wrong only 10% of the time • Results: < 1% of the subjects scored 9/10. Most missed 4-7 questions. • Most individuals are more confident of their knowledge than is warranted

5. Experiments – reliance on representatives • Tversky and Kahneman (1982) proposed a question to subjects and asked them to pick the more likely answer • Linda 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.

6. Experiments – behavioral bias • Kahneman & Tversky (1979) - 2 investment opportunities, A & B: • A yields sure profit of $240k • B yields $1mil w/25% probability & $0 w/75% probability • C & D: • C yields sure loss of $750k • D yields $0 w/25% probability & $1mil loss w/75% probability

7. 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 loss • B&C has $10k higher gain, $10k lower loss

8. Neuroscience Perspective • Parts of the brain: brain stem, limbic system, cerebral cortex • Physiological adaptations geared towards survival • Humans adapt to fit environmental conditions • [Investment] preferences may change as well • Competitiveness of global financial markets suggests Darwinian selection is also applicable • Unsuccessful market participants are eliminated after suffering certain losses

9. AMH - Adaptive Markets Hypothesis Uses a Darwinian perspective • financial markets = ecosystem • dealers = herbivores • speculators = carnivores • floor traders and distressed investors = decomposers

10. Adaptive Markets Hypothesis “Satsificing“ • Due to limited computational abilities • Making 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 environment • Become "maladaptive," fish out of water

11. Adaptive Markets Hypothesis AMH - 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.

12. Adaptive Markets Hypothesis Everything converges to equilibrium • Competition increase • Resource depleted • Decline in population • Less competition • Sometimes permanent loss of resource or extinction of species

13. Role of the Consultant Assists managers and investors in dealing with preferences. • Educate investors and managers • Assist in examine/modifying risk preferences • Matching investor and manager's perferences

14. Role of the Consultant Sensitive to changing markets. • Familiar with a wide spectrum of investment products and services Must continually seek education. • Financial technology • Advances in neuroscience • Training and certification programs

15. ApplicationsProblems • Still in its infancy • Much research must be done to establish viability • However, questions arise about the relevancy of AMH compared to previously established EMH • A wealth of tools exist for EMH • EMHs have a long history

16. Preferences Matter • Individual preferences have long been studied in a variety of pitfalls • Care 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 making • Psychological surveys are designed to capture broad characteristics of personality • Economists perform choice experiments • Market Researchers conduct field studies of consumer preferences

17. Advances in Studying Decision Making • Nueroscience • 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 basis • In order to help articulate and accurately represent the final goals of the individual

18. Revisiting Asset Allocation • Another facet of the AMH framework • Selection of portfolio weights for broad asset classes • Relation between risk and reward • Never stable over time

19. Insights from AMH • Aggregate risk preferences are constantly being shaped and reshaped over time • Natural selection process • Contrary to EMH arbitrage do exist from time to time • As profit opportunities come to light, they are exploited and disappear • New opportunities appear as older opportunities die out

20. Insights from AMH(Cont.) • Like profit opportunities, investment strategies wax and wane • Unlike 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

21. Insights from AMH(Cont.) • Value and growth may behave like risk factors from time to time • Portfolios with such characteristics may yield higher returns than periods when those factors are favorable

22. Bottom Line Regarding Active Asset Allocation • Policies may only be right for certain people under certain market conditions • AMH does not imply active asset allocation is any less difficult • Provides a rationale for the apparent cyclical nature of risk factors and points the way to promising new research directions

23. Dynamics of Competition and Market Ecology • Another key application of the AMH framework to investment management is the insight that innovation is the key to survival • EMH 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

24. For Consideration • Ask where the next financial asteroid will come from • The 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.

25. Innovation • Key to AMH Framework • Takes on an urgency generally missing from most financial decision making paradigms • EMH • Modern portfolio theory • Capital Asset Pricing Model (CAPM)

26. Role of Adaptive Markets in Machine Learning • Adaptive markets imply an every changing, however somewhat cyclical marketplace • Perfect for machine learning • If 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