Adaptive Market Hypothesis

The Adaptive Market Hypothesis

The Adaptive Market Hypothesis in Evolutionary Investing


The Adaptive Market Hypothesis is an idea in evolutionary investing.

Most know that the stock market isn’t really efficient. But it isn’t entirely random either. At least we know the stock market goes up over time!

The efficient market theory is derived from the ideal that Homo economicus efficiently uses her resources. On the flip side, the study of behavioral investing suggests that people are irrational and full of heuristics and biases.

Consider that continuum, from efficient to irrational, and you might make a stop in the middle with the adaptive market hypothesis.

Based upon evolutionary principles, the adaptive market hypothesis takes real humans (with all their foibles) into account yet still assumes the market is primarily rational and efficient.

Can the adaptive market hypothesis help us become better investors?


Adaptive Market Hypothesis

evolutionary investing

Above, you can see that the adaptive markets hypothesis sits between efficient markets and behavioral finance on a continuum. It is not a synthesis of the two; instead, it is a way to describe what actually happens in a messy world.

Markets are considered complicated non-linear systems that are similar to the evolution of species in nature. Some populations compete for limited resources. Those with a relative fitness advantage win (as measured by grandchildren in evolution and wealth in evolutionary investing).

Moreover, markets evolve.


Markets Evolve Over Time

To start, the stock market is a complex adaptive system (see more in my bit on Chaos theory and investing). Indeed, there is a degree of rational decision-making, but individual irrational investors do not infrequently make decisions (see my bit on Behavioral Investing for the DIY investor).

All models are wrong, but some are useful (remember Covid before it became endemic). The efficient market hypothesis has led to interesting models, but ones easily disproved. How can it explain momentum investing or stock market bubbles, among other phenomena?

Conversely, assume all people are irrational and acting on their biases all the time, and you will quickly lose your shirt.

Evolution provides biologists with tools that revolutionize biology and science more generally. Can evolutionary economics, the study of complex ecosystems (markets) viewed through adaptation (changing investments) and survival of genes (wealth), add to our understanding?

YES! theorizes Andrew Lo, the leading proponent of the adaptive markets hypothesis since as far back as 2005.


The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and little consensus exists as to which side is winning or the implications for investment management and consulting… Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants. Many of the examples that behavioralists cite as violations of rationality that are inconsistent with market efficiency – 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.

-Andrew Low


Basics of the Adaptive Markets Hypothesis

So, are markets efficient or full of behavioral biases? As is true in most aspects of life, the answer is likely somewhere in the middle. The adaptive markets hypothesis tries to fit the center.

Adaptive markets theory has five basic principles (with the evolutionary corollate in parentheses):

  • Investors act in their best self-interest (genes act in their own best self-interest)
  • Investors act irrationally at times (there is variability in the population through which natural selection acts)
  • From market mistakes come learning, innovation, and adaptation (mutations in genetics)
  • Natural selection acts upon individuals, institutions, and markets (natural selection picks winners and losers)
  • From a rational baseline market, add irrational aspects and, over time, change due to the evolutionary process (populations of gene-carriers change overtime)


So, specifically, the adaptive market hypothesis is about the delta: what is the change over time? Where are the inefficiencies? Are the periods in the market where equities are expected to outperform? Bonds? Themes? Sectors?

In essence, the adaptive market hypothesis attempts to predict non-factor tilts as the market evolves.

Further, the theory suggests that by monitoring the financial ecosystem (the whole economy), you can understand the relationship between interactions of individuals, institutions, hedge funds, and markets in general. Over time, you see how these relationships evolve, and you can pick the winners.

You can also reduce risk during high volatility and then go long when volatility shrinks.


My Thoughts on Evolutionary Investing from The Selfish Gene

Markets, investors and companies adapt, or they go extinct.

It is not survival of the fittest but rather survival of the gene. Richard Dawkins (The Selfish Gene) can parse that the gene’s survival is what matters rather than the survival of the species. By the way, beyond that fantastic insight, he is also the man who coined “Meme” in that very same book. Interesting, as meme sounds like gene and is selected for and against very much like other biological phenomena.

What is the gene that is selected for or against in evolutionary investing? It would have to be the individual stock and the forces that shape it, both up and down. After all, stocks compete for limited resources, sectors do well overtime at the expense of other sectors, and similar the economies of entire countries compete on a global scale. But the basic replicon is the corporation and its stock.

Dawkins’s Selfish Gene view of evolution helps explain altruism, religion, morality, ethics, fairness, and even language. By replicating genes, organisms that carry the genes have been programmed to survive in varied environments.

They creature culture and memes.

From this understanding of The Selfish Gene, evolutionary investing is a neat idea but fails my sniff test.


Why The Adaptive Market Hypothesis Fails the Sniff Test

In nature, heuristics of the past environments may not be well suited to new ones.

The same holds with different regimes in investing. Value works for a couple of years, but then growth works for several decades in a row. Heuristics of past successful investors will lead us astray because, as we all know, “this time it is different.”

The adaptive market hypothesis is a thinly veiled attempt at justifying market timing. It suggests that this time it is different, and using evolutionary theory, you can predict what to do.

While it is not useful to think the market is rational while people are irrational, adding evolutionary principles to this continuum falls flat.

Because the market is efficient enough, you cannot time the market or outperform the indices over long periods. Because individuals are irrational, you will have plenty of chaos.

What is offensive about the adaptive market hypothesis is how it believes risk/reward can be stratified. Changing market conditions, it suggests, lead to changes in how you take risk. All you need to do is wave the magic evolutionary wand, and you know a priori who will win.


Summary—Adaptive Market Hypothesis

The adaptive market hypothesis is an evolutionary approach to economics. It attempts to explain anomalies in a structured way, above what we understand from behavioral finance alone.

In sum: it is an apologist’s view on stock picking and market timing.

As it is folly to assume humans have evolved to our evolutionary pinnacle (after all, we are still evolving), it is folly to assume that markets will converge to any predictable expected equilibrium. Evolution, like the economy, is a random, chaotic process.

You cannot know what will result from any given set of inputs. In short: there is no way to predict the winner even if you know everything in advance.

Momentum investing and market crashes might be the most fertile ground for evolutionary investing. After all, efficient markets poorly predict these currents and waves. Is it, then, more than just the irrational investor?

Memes go a long way to explain irrationality in the market, and memes are a well-described evolutionary force. They are replicators, just like our genes.

Sometimes we are rational, and sometimes we are emotional—the result: millions of participants flipping trick coins with non-linear outcomes. Explaining what comes out on the other side of that mess is more than a neat trick. It is fantasy!


Evolutionary investing is “biology rather than physics.” Well, sure, biology is much messier.

Instead of equations, use nuance to understand how markets and risk change. From this, evolutionary investors glean actionable insights.

And that is my impression. The adaptive markets hypothesis suggests that asset pickers can outperform, just like how you can pick the eventual evolutionary winner in a completive niche.

Well, you cannot a priori pick the winners in evolution! Nor can you with evolutionary investing.

And this is why the adaptive market hypothesis is wrong. You cannot pick the winners beforehand in a complicated, chaotic non-linear system.



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