Evolutionary Investing- The Adaptive Market Hypothesis
The Adaptive Market Hypothesis is a concept from evolutionary investing.
The stock market isn’t efficient. But it isn’t entirely random, either.
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.
Between efficient and irrational, you might find 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
Above, you can see that the adaptive markets hypothesis sits between efficient markets and behavioral finance. It is not a synthesis of the two but a way to describe what happens in a messy world.
Markets are considered complicated nonlinear systems 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
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. 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 constantly act on their biases, 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 gene survival (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 genes change over time)
Specifically, the adaptive market hypothesis is about the delta: what changes over time? Where are the inefficiencies? Are the periods in the market where equities are expected to outperform? Bonds? Themes? Sectors?
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.
Evolutionary Investing and 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 also 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 gene 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 over time at the expense of other sectors, and 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.
Evolutionary investing is a neat idea based on this understanding of the Selfish Gene, but it fails my sniff test.
Why The Adaptive Market Hypothesis Fails the Sniff Test
In nature, heuristics of past environments may not be well suited to new ones.
The same holds with different investing regimes. Value works for a couple of years, but then growth works for several decades. 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 it is different this time, and you can predict what to do using evolutionary theory.
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 or outperform the indices over long periods. Because individuals are irrational, you will have plenty of chaos.
The adaptive market hypothesis is offensive because it believes risk/reward can be stratified. It suggests that changing market conditions lead to changes in how you take risk. You only need to 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.
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 can help explain irrationality in the market, and they are a well-described evolutionary force. They are replicators, just like our genes.
Sometimes, we are rational, and sometimes, we are emotional—the result is 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 risks change. From this, evolutionary investors glean actionable insights.
You cannot pick the winners in evolution a priori! Nor can you with evolutionary investing.
This is why the adaptive market hypothesis is wrong. In a complicated, chaotic, nonlinear system, you cannot pick the winners beforehand.
