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The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Journal of Portfolio Management, Forthcoming

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.

Number of Pages in PDF File: 33

Keywords: Market Efficiency, Behavioral Finance, Bounded Rationality

JEL Classification: G10, G12, G14

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Date posted: October 15, 2004  

Suggested Citation

Lo, Andrew W., The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective. Journal of Portfolio Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=602222

Contact Information

Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
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
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