The Lo in 2004, it is a theory

aim of this paper is to explain and contrast the Adaptive Markets Hypothesis
(AMH) and the Efficient Markets Hypothesis (EMH) and to evaluate both by
contrasting them and seeking their weaknesses. The EMH was developed by Roberts
and Fama, who claim that market prices fully reflect all available information.
The theory pushes claims that it is impossible to beat the market by gaining
abnormal returns. The AMH was developed Andrew Lo in 2004, it is a theory that
tries to connect behavioral finance with EMH principles – it is market
efficiency from an evolutionary perspective.

What is the Efficient Market Hypothesis?

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

The EMH suggests all markets are efficient, they can be distinguished by three
forms of market efficiency, with differing information levels – weak-form,
semi-strong and strong-form. There are no arbitrage opportunities in the EMH
because the EMH assumes that markets react quickly enough for there to be no
opportunity to do so.
The weak-form implies that past prices and data are already reflected in the
current prices. They do not have an effect on future prices and therefore are
not useful for investment choices. Share prices are seen as independent; there
are no patterns which leads to prices being seen to follow a ‘random walk’. This
voids the use of technical analysis (where investors cannot devise an
investment strategy to yield abnormal profits on the basis of an analysis of
past price patterns – Malkiel, 1989, page 127).
The semi-strong EMH implies that as well as historical price information for
stocks being reflected in an asset price, all information available to the
public is too (E.G. financial statements, investment plans, news reports). The
use of technical and fundamental analysis (where investors use information
released by companies for the public to find mispriced stocks) are futile in
this form of market as all investors react instantaneously to push the price to
reflect all public information. This means that the only way investors are able
to achieve superior gains is through knowledge that isn’t in the hands of the
public – however this could be seen as ‘insider trading’ which is illegal.

EMH implies that all information – historical, public and private is reflected
in the current prices – private information is information only known to
management or the board of directors. This form sees ‘insider trading’ as
impossible since no superior returns can be made since it is already reflected
in the price. Due to this, fundamental and technical analysis do not work in
this form of EMH.

What is the Adaptive Market Hypothesis?
Proposed by Andrew Lo, he states that the AMH can be seen as a new and
updated version of the EMH – “derived from evolutionary principles.” (Lo, 2004, page 18). It is a theory that tries to connect
EMH principles with behavioral finance principles. The AMH states that prices
are a reflection of environmental conditions and the “number of ‘species’ in
the economy” (Lo, 2004). ‘Species’ is defined as different market participants
in the economy; from hedge funds, mutual funds, retail investors, investment
banks all being different kind of’species’. The AMH states that if there are
many users of a particular market, it is going to be seen as highly efficient
and if there are few and far between users of another particular market, it is
going to be seen as less efficient. Lo’s theory can be explained through these
primary ideas: “Individuals act in their own self-interest, individuals make
mistakes, individuals learn and adapt, competition drives adaption and
innovation, natural selection shapes market ecology and evolution determines
market dynamics” (Lo, 2005, page 11). The AMH offers a whole plethora more of
market participant’s decisions, where the EMH assumes market participants act
in the most optimum way.

Contrasting EMH and AMH:


very existence of AMH weakens any argument in favour of EMH because ultimately,
the AMH builds on the foundations laid by EMH. The biggest difference between
EMH and AMH, and perhaps the main reason that EMH is so widely criticised is
that it does not account for human behaviour. Lo – 2005, described EMH as “far
reaching” because it is irrational to think that human error, intention and
knowledge does not exist. He calls market efficiency “not an all-or-none
condition but a characteristic that varies continuously over time and across
markets.” (Lo, 2005).


the AMH, the EMH can be tested by using event studies to attempt to prove what
form a market is in. Event studies examine market reactions and abnormal
returns around specific information events such as earnings or dividends
announcements. It can be seen how long the market takes to reflect information
into a stock price. The test is performed by collecting a sample of firms that
had a surprise announcement, determining the precise day of the announcement,
defining an event window and computing the return and abnormal return on each
day studied and calculating the average abnormal return (by subtracting normal
return from the abnormal return).


Weakness with the

One disadvantage of EMH comes from Farmer and Lo’s ‘Frontiers of
Finance: Evolution and efficient markets.’ This idea discusses that “EMH, by
itself, is not a well posed and empirically refutable hypothesis” (Farmer, Lo
-1999). This, according to Farmer and Lo, is because it cannot be operational
without considering external factors such as investor’s preferences. The
problem with a need for added external information us that it means that
technically, the EMH cannot work by itself and so it cannot give us practical
and applicable data on its own. However, they go on to say that a more useful
way to use EMH is see it from a biological view point where “markets,
instruments, institutions, and investors interact and evolve dynamically
according to the “law” of economic selection.” (Farmer, Lo -1999). This
comparison demonstrates that financial markets should be viewed as an adaptable
process which would mean that more consideration would be given to the fact
that financial agents compete and adapt with change, but it is not always done
so in a predictable and “optimal” fashion. Ultimately, they view that financial
theories should be based more on realistic and measurable approaches to make
them more efficient and reliable.

Another weakness of the EMH lies within the weak-form EMH. Since
the form states that past prices are reflected in the price, past market data
is useless for investment strategies. However, some analysts believe that, in
some circumstances, past market data can in fact be useful through the use of
moving averages and trading range breaks.
Since the EMH believes all markets are efficient (level depends on which form
of efficient the market it), abnormal returns are seen as impossible. This
assumption can be countered by the proof of real life examples of people/funds
regularly beating the market. Albeit hedge funds are secretive in their ways,
some are known to be regularly beating the markets for good returns. Warren
Buffet is another example of someone who has regularly beat the market – the
proof lies within his success in ownership of his company Berkshire Hathway.

There is a well known joke/story where a finance professor
and student walk a path and come across a $100 note on the floor. As the
student goes to pick up the note, the professor calmly says “don’t bother – if
it was a real $100 note, someone would have picked up the note already”. Both
Lo (2004) and Malkiel (2003) use this as an analogy to explain what the EMH/AMH
explains the term ‘efficient’ to be. Lo uses the story as an “example of
economic logic gone awry, that it is a fairly accurate rendition of the EMH”,
claiming that the EMH has not had its fair share of criticism, that the EMH is
“resilient to empirical proof or refutation” (Lo, 2004).
In contrast, Malkiel uses the joke/story to explain that the interpretation of
the word efficient; that in a market no investor has the opportunity to pick up
a free $100 note without any risk. This shows that both theories believe that
markets are “amazingly successful devices for reflecting new information
rapidly & … accurately” (Malkiel, 2003).

Weakness with the AMH:

first implication with the AMH is that unlike EMH, arbitrage opportunities are
possible. Although exploiting arbitrage opportunities is a legal practice, it
can be argued that it is spawned from market inefficiency; that the market
isn’t efficient enough to reflect the necessary prices for arbitrage
opportunities to not exist. Grossman and Stiglitz (1980) test and observe that
without arbitrage opportunities, “there will be no incentive to gather
information, and the price-discovery aspect of financial markets will collapse”
(Lo, 2004). This offers insight that perhaps arbitrage opportunities help make
the markets more efficient.


the relationship between the risk and reward individuals take for AMH’s theory
is hard to measure accurately. For Lo’s theory, it implies that risk and reward
changes throughout time and being able to measure the risk and reward would
help with proving his assumptions of the way market participants act. The
relationship between risk and reward is determined by the amount of active
participants in a market and their preferences, as well as “institutional
aspects such as the regulatory environment and tax laws” (Lo, 2004). These
factors do not stay constant, they change day-to-day with participant activity/preference
and potentially yearly with institutional aspects.


the AMH takes the assumption that survival is the only target for market
participants. It’s obvious that market participants have more objectives than
just to simply ‘survive’; “profit maximization, utility maximization and
general equilibrium” (Lo, 2004) are relevant in most cases for investors.



Adaptive Market Hypothesis is the more advanced theory, compared to the
Efficient Market Hypothesis. The justification for this is that the AMH offers
insight to human behavior in the financial markets where investors make
mistakes and adapt, whereas the EMH assumes all market participants operate at
an optimum level. The AMH uses evolutionary principles to explain EMH logic of
market efficiency with behavioral finance; which is essential to understanding
if markets are efficient.


the EMH has proof that counters its assumptions. The EMH claims that historical
information is not useful in weak-form markets (which is countered by the fact
moving averages and trading ranges from historical data can be useful in
predicting future prices). It also assumes that making abnormal returns
consistently is impossible, where some funds and individuals are known to beat
the market on a consistent basis.


being said, the AMH does have some noticeable flaws with its own assumptions
and its ability to be tested. The AMH assumes investors are in the market for nothing
but survival, but simple logic that most investors are in the market for
profit/utility maximization counters this assumption. Lo’s assumption that risk
and reward change over time cannot be tested accurately due to changes in
investors behavior and to institutional aspects.


theories can be seen as quite similar since the foundations of the AMH is based
on the EMH’s less ‘far fetched’ logic. The AMH’s ability to give a whole
plethora of extra information regarding human decision and activity is what
gives it the upper hand against the EMH.