The adaptive markets hypothesis

Abstract

One of the most influential ideas in the past 30 years is the efficient markets hypothesis, the idea that market prices incorporate all information rationally and instantaneously. The emerging discipline of behavioral economics and finance has challenged the EMH, arguing that markets are not rational, but rather driven by fear and greed. Research in the cognitive neurosciences suggests these two perspectives are opposite sides of the same coin. An adaptive markets hypothesis that reconciles market efficiency with behavioral alternatives applies the principles of evolution-competition, adaptation, and natural selection-to financial interactions. Extending Simon's notion of "satisficing" with evolutionary dynamics, the author argues that much of what behaviorists cite as counter-examples to economic rationality-loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases-is in fact consistent with an evolutionary model of individual adaptation to a changing environment via simple heuristics. The adaptive markets hypothesis offers a number of surprisingly concrete implications for portfolio management.