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Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis


Andrew W. Lo


Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

2005

Journal of Investment Consulting, Vol. 7, No. 2, pp. 21-44, 2005

Abstract:     
The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and little consensus exists as to which side is winning or the implications for investment management and consulting. In this article, I review the case for and against the Efficient Markets Hypothesis and describe a new framework - the Adaptive Markets Hypothesis - in which the traditional models of modern financial economics can coexist alongside behavioral models in an intellectually consistent manner. 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. Many of the examples that behavioralists cite as violations of rationality that are inconsistent with market efficiency - loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases - are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, I show that the Adaptive Markets Hypothesis yields a number of surprisingly concrete applications for both investment managers and consultants.

Number of Pages in PDF File: 28

Keywords: Behavioral Finance, Market Efficiency, Efficient Markets Hypothesis, Adaptive Markets Hypothesis

JEL Classification: G10, G11, G14


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Date posted: November 5, 2010  

Suggested Citation

Lo, Andrew W., Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis (2005). Journal of Investment Consulting, Vol. 7, No. 2, pp. 21-44, 2005. Available at SSRN: https://ssrn.com/abstract=1702447

Contact Information

Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www

National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)
Stata Center
Cambridge, MA 02142
United States
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