Michael Chan
John Hautzinger
Constance Jiang
 Efficient Markets Hypothesis (EMH)
 Propose new framework, Adaptive Markets Hypothesis
(AMH), reconciling EMH with behavioral biases
Efficient Markets Hypothesis
 The notion that markets fully, accurately, and
instantaneously incorporate all available information
into market prices
 Participants are rational beings always making optimal
choices in self-interest
 Psychologists and experimental economists have
documented behavioral biases that do not follow
market rationality
 EMH criticizes behavior as observations without
principles to explain the origin
Experiments - overconfidence
 Russo & Shoemaker (1989) – subjects asked to give
90% confidence answers(ranges) in response to
questions w/numerical answers
 Subjects should be wrong only 10% of the time
 Results: < 1% of the subjects scored 9/10. Most missed 4-
7 questions.
 Most individuals are more confident of their
knowledge than is warranted
Experiments – reliance on
 Tversky and Kahneman (1982) proposed a question to
subjects and asked them to pick the more likely
 Linda is 31 years old, single, outspoken, and very bright.
She majored in philosophy. As a student, she was deeply
concerned w/ issues of discrimination & social justice, &
participated in anti-nuclear demonstrations. Check the
more likely alternative
Linda is a bank teller
Linda is a bank teller and is active in the feminist movement.
Experiments – behavioral bias
 Kahneman & Tversky (1979) - 2 investment
opportunities, A & B:
 A yields sure profit of $240k
 B yields $1mil w/25% probability & $0 w/75% probability
 C & D:
 C yields sure loss of $750k
 D yields $0 w/25% probability & $1mil loss w/75%
Experiments – behavioral
 A&D equivalent to:
 25% chance of $240k yield, 75% chance of $760k loss
 B&C equivalent to:
 25% chance of $250k yield, 75% chance of $750k loss
 B&C has $10k higher gain, $10k lower loss
Neuroscience Perspective
 Parts of the brain: brain stem, limbic system, cerebral
 Physiological adaptations geared towards survival
 Humans adapt to fit environmental conditions
 [Investment] preferences may change as well
 Competitiveness of global financial markets suggests
Darwinian selection is also applicable
 Unsuccessful market participants are eliminated after
suffering certain losses
AMH - Adaptive Markets
Uses a Darwinian perspective
 financial markets = ecosystem
 dealers = herbivores
 speculators = carnivores
 floor traders and distressed investors = decomposers
Adaptive Markets Hypothesis
 Due to limited computational abilities
 Making choices to meet satisfactory standards.
How to determine what's satisfactory?
 Pos/Neg reinforcement leads to learning.
 When economic challenges stabilize, there's your optimal
Change of environment
 Become "maladaptive," fish out of water
Adaptive Markets Hypothesis
AMH - the new EMH
 (A1) Individuals act in their own self-interest.
 (A2) Individuals make mistakes.
 (A3) Individuals learn and adapt.
 (A4) Competition drives adaptation and innovation.
 (A5) Natural selection shapes market ecology.
 (A6) Evolution determines market dynamics.
Adaptive Markets Hypothesis
Everything converges to equilibrium
 Competition increase
 Resource depleted
 Decline in population
 Less competition
 Sometimes permanent loss of resource or extinction of
Role of the Consultant
Assists managers and investors in dealing with
Educate investors and managers
Assist in examine/modifying risk preferences
Matching investor and manager's perferences
Role of the Consultant
Sensitive to changing markets.
 Familiar with a wide spectrum of investment products
and services
Must continually seek education.
 Financial technology
 Advances in neuroscience
 Training and certification programs
 Still in its infancy
 Much research must be done to establish viability
 However, questions arise about the relevancy of AMH
compared to previously established EMH
 A wealth of tools exist for EMH
 EMHs have a long history
Preferences Matter
 Individual preferences have long been studied in a
variety of pitfalls
 Care must be taken to avoid pitfalls
 Pitfalls must first be known in order to avoid them
 Each industry focuses on a different aspect of decision
 Psychological surveys are designed to capture broad
characteristics of personality
 Economists perform choice experiments
 Market Researchers conduct field studies of consumer
Advances in Studying Decision
 Nueroscience
 Decisions are interactions between specialized parts of
the brain
 Use of a combination of survey techniques must be used
to achieve desired results
 Work must be done with investors on an individual
 In order to help articulate and accurately represent the
final goals of the individual
Revisiting Asset Allocation
 Another facet of the AMH framework
 Selection of portfolio weights for broad asset classes
 Relation between risk and reward
 Never stable over time
Insights from AMH
 Aggregate risk preferences are constantly being shaped
and reshaped over time
 Natural selection process
 Contrary to EMH arbitrage do exist from time to time
 As profit opportunities come to light, they are exploited
and disappear
 New opportunities appear as older opportunities die out
Insights from AMH
 Like profit opportunities, investment strategies wax
and wane
 Unlike EMH in which opportunities are competed away,
AMH allows for the assumption that opportunities may
decline, but will return
 Example: Risk Arbitrage
Became unprofitable in the decline of 2001
As pace mergers and acquisitions increase, risk arbitrage will
come back to profitability
Insights from AMH
 Value and growth may behave like risk factors from
time to time
 Portfolios with such characteristics may yield higher
returns than periods when those factors are favorable
Bottom Line Regarding
Active Asset Allocation
 Policies may only be right for certain people under
certain market conditions
 AMH does not imply active asset allocation is any less
 Provides a rationale for the apparent cyclical nature of
risk factors and points the way to promising new
research directions
Dynamics of Competition
and Market Ecology
 Another key application of the AMH framework to
investment management is the insight that innovation
is the key to survival
 EMH suggests that certain levels of expected returns can
be achieved simply by bearing a sufficient degree of risk.
 AMH implies that the risk/reward relation varies
through time and that a better way of achieving a
consistent level of expected returns is to adapt to
changing market conditions
For Consideration
 Ask where the next financial asteroid will come from
 The AMH has a clear implication for all financial market
Survival is ultimately the only objective that matters
Profit maximization, utility maximization, and general
equilibrium are certainly relevant aspects of market ecology
The organizing principle in determining the evolution of
markets and financial technology is simply survival.
 Key to AMH Framework
 Takes on an urgency generally missing from most
financial decision making paradigms
Modern portfolio theory
Capital Asset Pricing Model (CAPM)
Role of Adaptive Markets
in Machine Learning
 Adaptive markets imply an every changing, however
somewhat cyclical marketplace
 Perfect for machine learning
 If truly cyclical then machine learning could use known
parameters to predict outcomes in the short and long
 ML allows for consideration of all aspects of the decision

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