Theaim of this paper is to explain and contrast the Adaptive Markets Hypothesis(AMH) and the Efficient Markets Hypothesis (EMH) and to evaluate both bycontrasting them and seeking their weaknesses. The EMH was developed by Robertsand Fama, who claim that market prices fully reflect all available information.The theory pushes claims that it is impossible to beat the market by gainingabnormal returns. The AMH was developed Andrew Lo in 2004, it is a theory thattries to connect behavioral finance with EMH principles – it is marketefficiency from an evolutionary perspective.
What is the Efficient Market Hypothesis?The EMH suggests all markets are efficient, they can be distinguished by threeforms of market efficiency, with differing information levels – weak-form,semi-strong and strong-form. There are no arbitrage opportunities in the EMHbecause the EMH assumes that markets react quickly enough for there to be noopportunity to do so. The weak-form implies that past prices and data are already reflected in thecurrent prices. They do not have an effect on future prices and therefore arenot useful for investment choices. Share prices are seen as independent; thereare no patterns which leads to prices being seen to follow a ‘random walk’. Thisvoids the use of technical analysis (where investors cannot devise aninvestment strategy to yield abnormal profits on the basis of an analysis ofpast price patterns – Malkiel, 1989, page 127). The semi-strong EMH implies that as well as historical price information forstocks being reflected in an asset price, all information available to thepublic is too (E.
G. financial statements, investment plans, news reports). Theuse of technical and fundamental analysis (where investors use informationreleased by companies for the public to find mispriced stocks) are futile inthis form of market as all investors react instantaneously to push the price toreflect all public information. This means that the only way investors are ableto achieve superior gains is through knowledge that isn’t in the hands of thepublic – however this could be seen as ‘insider trading’ which is illegal.Strong-formEMH implies that all information – historical, public and private is reflectedin the current prices – private information is information only known tomanagement or the board of directors. This form sees ‘insider trading’ asimpossible since no superior returns can be made since it is already reflectedin the price. Due to this, fundamental and technical analysis do not work inthis form of EMH.What is the Adaptive Market Hypothesis?Proposed by Andrew Lo, he states that the AMH can be seen as a new andupdated version of the EMH – “derived from evolutionary principles.
” (Lo, 2004, page 18). It is a theory that tries to connectEMH principles with behavioral finance principles. The AMH states that pricesare a reflection of environmental conditions and the “number of ‘species’ inthe economy” (Lo, 2004). ‘Species’ is defined as different market participantsin the economy; from hedge funds, mutual funds, retail investors, investmentbanks all being different kind of’species’.
The AMH states that if there aremany users of a particular market, it is going to be seen as highly efficientand if there are few and far between users of another particular market, it isgoing to be seen as less efficient. Lo’s theory can be explained through theseprimary ideas: “Individuals act in their own self-interest, individuals makemistakes, individuals learn and adapt, competition drives adaption andinnovation, natural selection shapes market ecology and evolution determinesmarket dynamics” (Lo, 2005, page 11). The AMH offers a whole plethora more ofmarket participant’s decisions, where the EMH assumes market participants actin the most optimum way.Contrasting EMH and AMH: Thevery existence of AMH weakens any argument in favour of EMH because ultimately,the AMH builds on the foundations laid by EMH. The biggest difference betweenEMH and AMH, and perhaps the main reason that EMH is so widely criticised isthat it does not account for human behaviour. Lo – 2005, described EMH as “farreaching” because it is irrational to think that human error, intention andknowledge does not exist. He calls market efficiency “not an all-or-nonecondition but a characteristic that varies continuously over time and acrossmarkets.” (Lo, 2005).
Unlikethe AMH, the EMH can be tested by using event studies to attempt to prove whatform a market is in. Event studies examine market reactions and abnormalreturns around specific information events such as earnings or dividendsannouncements. It can be seen how long the market takes to reflect informationinto a stock price. The test is performed by collecting a sample of firms thathad a surprise announcement, determining the precise day of the announcement,defining an event window and computing the return and abnormal return on eachday studied and calculating the average abnormal return (by subtracting normalreturn from the abnormal return).
Weakness with theEMH: One disadvantage of EMH comes from Farmer and Lo’s ‘Frontiers ofFinance: Evolution and efficient markets.’ This idea discusses that “EMH, byitself, is not a well posed and empirically refutable hypothesis” (Farmer, Lo-1999). This, according to Farmer and Lo, is because it cannot be operationalwithout considering external factors such as investor’s preferences. Theproblem with a need for added external information us that it means thattechnically, the EMH cannot work by itself and so it cannot give us practicaland applicable data on its own. However, they go on to say that a more usefulway to use EMH is see it from a biological view point where “markets,instruments, institutions, and investors interact and evolve dynamicallyaccording to the “law” of economic selection.” (Farmer, Lo -1999). Thiscomparison demonstrates that financial markets should be viewed as an adaptableprocess which would mean that more consideration would be given to the factthat financial agents compete and adapt with change, but it is not always doneso in a predictable and “optimal” fashion.
Ultimately, they view that financialtheories should be based more on realistic and measurable approaches to makethem more efficient and reliable.Another weakness of the EMH lies within the weak-form EMH. Sincethe form states that past prices are reflected in the price, past market datais useless for investment strategies. However, some analysts believe that, insome circumstances, past market data can in fact be useful through the use ofmoving averages and trading range breaks.Since the EMH believes all markets are efficient (level depends on which formof efficient the market it), abnormal returns are seen as impossible. Thisassumption can be countered by the proof of real life examples of people/fundsregularly beating the market. Albeit hedge funds are secretive in their ways,some are known to be regularly beating the markets for good returns. WarrenBuffet is another example of someone who has regularly beat the market – theproof lies within his success in ownership of his company Berkshire Hathway.
There is a well known joke/story where a finance professorand student walk a path and come across a $100 note on the floor. As thestudent goes to pick up the note, the professor calmly says “don’t bother – ifit was a real $100 note, someone would have picked up the note already”. BothLo (2004) and Malkiel (2003) use this as an analogy to explain what the EMH/AMHexplains the term ‘efficient’ to be. Lo uses the story as an “example ofeconomic 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 ofthe word efficient; that in a market no investor has the opportunity to pick upa free $100 note without any risk. This shows that both theories believe thatmarkets are “amazingly successful devices for reflecting new informationrapidly & … accurately” (Malkiel, 2003). Weakness with the AMH:Thefirst implication with the AMH is that unlike EMH, arbitrage opportunities arepossible.
Although exploiting arbitrage opportunities is a legal practice, itcan be argued that it is spawned from market inefficiency; that the marketisn’t efficient enough to reflect the necessary prices for arbitrageopportunities to not exist. Grossman and Stiglitz (1980) test and observe thatwithout arbitrage opportunities, “there will be no incentive to gatherinformation, and the price-discovery aspect of financial markets will collapse”(Lo, 2004). This offers insight that perhaps arbitrage opportunities help makethe markets more efficient.
Secondly,the relationship between the risk and reward individuals take for AMH’s theoryis hard to measure accurately. For Lo’s theory, it implies that risk and rewardchanges throughout time and being able to measure the risk and reward wouldhelp with proving his assumptions of the way market participants act. Therelationship between risk and reward is determined by the amount of activeparticipants in a market and their preferences, as well as “institutionalaspects such as the regulatory environment and tax laws” (Lo, 2004).
Thesefactors do not stay constant, they change day-to-day with participant activity/preferenceand potentially yearly with institutional aspects. Moreover,the AMH takes the assumption that survival is the only target for marketparticipants. It’s obvious that market participants have more objectives thanjust to simply ‘survive’; “profit maximization, utility maximization andgeneral equilibrium” (Lo, 2004) are relevant in most cases for investors. Conclusion:TheAdaptive Market Hypothesis is the more advanced theory, compared to theEfficient Market Hypothesis. The justification for this is that the AMH offersinsight to human behavior in the financial markets where investors makemistakes and adapt, whereas the EMH assumes all market participants operate atan optimum level. The AMH uses evolutionary principles to explain EMH logic ofmarket efficiency with behavioral finance; which is essential to understandingif markets are efficient. Moreover,the EMH has proof that counters its assumptions. The EMH claims that historicalinformation is not useful in weak-form markets (which is countered by the factmoving averages and trading ranges from historical data can be useful inpredicting future prices).
It also assumes that making abnormal returnsconsistently is impossible, where some funds and individuals are known to beatthe market on a consistent basis. Thatbeing said, the AMH does have some noticeable flaws with its own assumptionsand its ability to be tested. The AMH assumes investors are in the market for nothingbut survival, but simple logic that most investors are in the market forprofit/utility maximization counters this assumption. Lo’s assumption that riskand reward change over time cannot be tested accurately due to changes ininvestors behavior and to institutional aspects.
Boththeories can be seen as quite similar since the foundations of the AMH is basedon the EMH’s less ‘far fetched’ logic. The AMH’s ability to give a wholeplethora of extra information regarding human decision and activity is whatgives it the upper hand against the EMH.