Adaptive Investment Approach
21 Pages Posted: 25 Nov 2013
Date Written: November 23, 2013
During the last decade, two deep bear markets, as results of tech bubble and mortgage crisis, have challenged the conventional wisdoms such as modern portfolio theory (MPT) and Efficient Market Hypothesis (EMH). As an alternative, the Adaptive Markets Hypothesis (AMH), proposed by Lo (2004, 2005, 2012), in which intelligent but fallible investors constantly adapt to changing market conditions, helps explain the importance of macro factors and market sentiment in driving asset returns. In this paper, I examine some of the shortcomings of the MPT and EMH, as well as the drawbacks in their applications. More importantly, I introduce the framework of adaptive investment approach, under which investors can adjust their investments to reflect economic regimes, ongoing market return or market volatility. Some of the investment strategies such as regime-based investing, momentum strategy, trend following or risk parity fall into the framework. This approach has the potential to deliver consistent returns in any market environments, by dynamically positioning in the financial assets perceived to have best return potential under the ongoing market and economic condition. For example, in the risk-seeking (“risk on”) environment, the strategy allocates to risky assets such as equities, commodities, real estates or high yield bonds; in the risk-avoidance (“risk off”) environment, the strategy invests in safe assets such as Treasuries or cash. Instead of forecasting future returns under the traditional active investment framework, the adaptive approach focuses more on identifying the market regimes and conditions and adjusting the investment strategies accordingly. In the end, I show that this approach can help enhance returns and diversify risks in the context of asset allocation.
Keywords: adaptive investment; adaptive market hypothesis; asset allocation; dynamic investment strategy; regime-based investing; momentum; trend following; risk parity; volatility-weigthted portfolio
JEL Classification: G10; G11; G12
Suggested Citation: Suggested Citation