The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective
33 Pages Posted: 15 Oct 2004
Abstract
One of the most influential ideas in the past 30 years is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution - competition, adaptation, and natural selection - to financial interactions. By extending Herbert Simon's notion of "satisficing" with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality - 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, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.
Keywords: Market Efficiency, Behavioral Finance, Bounded Rationality
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
On the Survival of Overconfident Traders in a Competitive Securities Market
By Guo Ying Luo and David Hirshleifer
-
Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis
By Andrew W. Lo
-
Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis
By Andrew W. Lo
-
Evolution and Market Competition
By Guo Ying Luo
-
Natural Selection and Market Efficiency in a Futures Market with Random Shocks
By Guo Ying Luo
-
The Evolution of Money as a Medium of Exchange
By Guo Ying Luo
-
By Thomas J. Brennan and Andrew W. Lo
-
Warning: Physics Envy May be Hazardous to Your Wealth!
By Andrew W. Lo and Mark T. Mueller
-
By Andrew W. Lo
-
Efficiency and Noise Traders in a One-Sided Auction Market
By Guo Ying Luo