The key implication of the efficient market hypothesis, the dominant market theory for the past two decades, is that it is impossible for investors to consistently beat the return of the stock market on a risk-adjusted basis.
In addition, the efficient market hypothesis assumes investors act rationally at all times and attempt to maximize the expected utility of their risk and return decisions.
But if the market is efficient, and investors act rationally, why do so many investors still seek active management returns? And why do market bubbles occur?
Recent studies in behavioral finance show, in fact, investors are "often — if not always — irrational, exhibiting predictable and financially ruinous behavior," according to Andrew Lo, Harris & Harris Group Professor and director, Massachusetts Institute of Technology Laboratory for Financial Engineering in Boston.
Mr. Lo has proposed a different hypothesis that incorporates the insights offered by behavioral finance into capital markets theory.
In effect, his "adaptive market hypothesis" attempts to reconcile the concepts underlying the efficient market hypothesis with behavioral finance revelations about the way people actually behave.
Mr. Lo's hypothesis assumes that individuals make choices that are merely satisfactory, not necessarily optimal. That is, they are "satisficers" not "optimizers". That's because "optimization is costly, and humans are naturally limited in their computational abilities."
In a paper published last August, "The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective" (available on his website http://web.mit.edu/
alo/www/), Mr. Lo argued that individuals make choices based on past experience and their "best guess" as to what might be satisfactory for them. They use shortcuts based on experience to make decisions on the various economic challenges they face. As long as the challenges remain stable, these shortcuts will eventually adapt to yield approximately optimal solutions. If the environment changes, however, the old rules may no longer work. They appear to be "behavioral biases".
Mr. Lo's hypothesis says prices reflect as much information as dictated by the combination of environmental conditions (e.g. market conditions) and the number and nature of distinct groups of market participants, each behaving in a common manner. For example, he wrote, pension funds, retail investors, market makers and hedge funds all may be considered distinct groups.
Under his hypothesis, because people use shortcuts to help in decision making, behavioral biases abound.
The effect of these biases on the market is determined by the size of the group with a bias relative to the sizes of groups using more effective decision models. That is, any relationship between risk and reward is unlikely to be stable, and is determined by the relative sizes and preferences of the various populations in the market.
Under his hypothesis, contrary to the efficient market hypothesis, arbitrage opportunities exist from time to time. Also, investment strategies will wax as more investors adopt an apparently successful strategy. This will drive down the returns on the strategy, causing it to be unsuccessful and fall out of favor for a time, until returns grow again.
Perhaps the most important implication of Mr. Lo's hypothesis is that "innovation is the key to survival."
Mr. Lo's hypothesis implies the risk/reward relationship varies through time, and that the way to achieve "a consistent level of expected returns is to adapt to changing market conditions."
