Introduction to the adaptive markets hypothesis

The following is an extract from a note that was recently sent to investors in the Montaka Global Fund. The second best book that I read in 2017 was Professor Andrew Lo’s Adaptive Markets: Financial Evolution at the Speed of Thought.

Adaptive Markets is mandatory reading for any serious professional who studies financial markets. It shines a light on many of the obvious flaws of the prevailing market philosophies out there. The Efficient Market Hypothesis (that basically means price = value) – can very easily be disproven and yet this is what continues to be taught in most finance classes around the world.

As value investors, we believe that price and value can deviate in the short run (representing the opportunities for us to invest). This is a required premise for value investing to exist. And while we observe this to be true on a daily basis, it is much more difficult to explain why it is so.

Professor Lo digs into the psychology of the participants of the markets (i.e. humans) and considers how humans evolve to new conditions to survive under the theory of evolution. He applies these concepts to financial markets in a fascinating way.

According to Lo, under the Adaptive Markets Hypothesis (AMH): The starting point is that the financial system isn’t a physical or mechanical system, but an ecosystem – a collection of interdependent species all struggling for survival and reproductive success in and ever-changing environment.

Lo summarises the AMH with five key principles.

AMH – five key principles:

1. We are neither always rational nor irrational, but we are biological entities whose features and behaviours are shaped by the forces of evolution.
2. We display behavioural biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback.
3. We have the capacity for abstract thinking, specifically forward-looking what-if analysis; predictions about the future based on past experience; and preparation for changes in our environment. This is evolution at the speed of thought, which is different from but related to biological evolution.
4. Financial markets are driven by our interactions as we behave, learn, and adapt to each other, and to the social, cultural, political, economic, and natural environments in which we live.
5. Survival is the ultimate force driving competition, innovation, and adaptation.

AMH refuses to label seemingly irrational behaviour as irrational. It recognizes that suboptimal behaviour is going to happen when we take heuristics out of the environmental context in which they emerged.

Lo gives a number of examples in which his AMH framework can be used to explain historical observations.

Example 1: The investor who buys near the top of a bubble because she first developed her portfolio management skills during an extended bull market is an example of “maladaptive behaviour.” There may be a compelling reason for the behaviour, but it’s not the most ideal behaviour for the current environment.

Example 2: Many hedge funds declined or became extinct in the bear market of 1969, and for a very basic reason: they failed to hedge. In the friendly financial climate of the preceding years, it was possible for a fund to do well without properly managing risk. In the happy environment, the hedge fund managers skimped on the long/short hedging strategy, preferring to hold highly leveraged long positions instead. When the change in financial environment came, it struck those funds the hardest. These new species of hedge fund, too closely adapted to the bull market environment of the late 1960s, became extinct.

Lo provides a lot of food for thought for today’s investor. Will the strategies that thrived over the last eight years (i.e. passive index funds) thrive over the next eight years? Or was this simply the strategy that worked well for the environment at the time? And when the environment changes, how many investors will be agile enough to adapt their portfolios to the new strategies?

As an aside, the best book I read in 2017 by far was Phil Knight’s Shoe Dog for what it’s worth.

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