Adaptive market hypothesis is a model which combines the principles of the effective market hypothesis with those of behavioral finance. This theory was suggested by MIT Professor Andrew Lo in 2004. The behavioral finance was established after an observation was made which concluded that people are not rational as the economic and market theories assume. Professor Lo claims that there are some behaviors exhibited by the investors such as loss avoidance, boldness, and overreaction which agrees with the evolutionary theories of human behavior such as natural selection, adaptations, and competition. Also, fear and greed which are seen as the main factor why these investors fail to think rationally are also determined by these evolutionary forces.
While efficient market hypothesis principles are irrational, behavioral finance principles are rational; the adaptive market hypothesis tries to reconcile the two. The hypothesis states that people make the best prediction on trial and error bases. For instance, an investor may come up with a certain strategy and use it, if the strategy succeeds, the investor is likely to use it again but if it fails, he is likely to try a different approach.
The efficient market hypothesis was developed by Eugene Fama who claims that it is impossible to conquer the market since stocks always sell at their best fair price. This makes it difficult for the investors to sell stocks at inflated prices and also it is impossible to purchase low valued stock. Generally, It is difficult to conquer the market by applying a stock selection or market selection and the only possible way an investor can use to conquer the market and expect higher returns is by chance. Eugene Fama did a study with Kenneth French showed that the abnormal distribution of US mutual funds is the same as what was expected even when the fund managers have had no skills.
Behavioral finance suggests a psychology-based approach which explains the differences in stock market such as the rise and falls of stock prices. The main aim of this theory is to understand why humans make specific financial choices. It claims that the structure of the market affects the individuals financial decision and overall the market consequences. According to MIT Professor Lo, the Adaptive market hypothesis can be concluded in five main principles:
Humans are not rational or irrational always but they are biological units whose behaviors and features are based on evolutionary forces.
Humans have behavioral preferences resulting into substandard decisions. However, they are able to learn from their past experience.
Humans have the ability to think intellectually and predict the future based on their previous experience of environmental changes.
Financial market changes are determined by the way humans behave, adapt to each other and the way they adapt to the social, economic, political, cultural and natural environment where they live.
Survive is the most crucial factor that drives competition, adaptation, and innovation.