Adaptive Expectations Details

We can never be sure of the future, especially in the world of finance, and we might be reluctant to make big business moves due to fear of external factors. Still, people try to make the best predictions they can and go with the risk—it's part of investment, weighing risk. However, when people see a historical pattern that is bound to repeat itself, they can adjust their expectations of what the future may hold for an investment.

Adaptive expectations is just that—the idea that people will change their predictions or expectations based on past events.

Adaptive Expectations Example

During times of political unrest and economic instability, the economy often declines. People sell their stocks. They may lose their jobs and so don't have enough money to inject into the economy. Riots could destroy businesses, divide governments, and shut down integral manufacturing processes. If analysts detect political unrest or financial decline, they would look to these historical instances and make their predictions accordingly.

For example, during The Great Depression, unemployment rates hit 25% by 1933. Experts still can't pinpoint one exact cause of the Depression, but they can trace it back to a few factors:

  • Too many people were buying things on credit.
  • Inflation rates were decreasing.
  • Manufacturers were producing more than people could buy.

This caused a domino effect. Manufacturers weren't making enough money to keep people employed. They laid those people off. An increasing number of people didn't have money to buy new products and therefore, factories were losing even more money, and the vicious cycle continued.

With this in mind, if analysts initially predict that a market will increase by 150% within two years, investors will gear their investments towards that particular market. However, suppose the same analysts see that halfway through the year, sales in that market are dramatically decreasing and factories are left with huge amounts of surplus. In that case, they will adjust their predictions to fit the situation. Looking back at the vicious cycle of the Great Depression, they predict that the market will spiral and crash and that investors may want to change direction. Sales (demand) won't support the need to supply the product and keep people employed in those factories.

Adaptive Expectations vs. Rational Expectations

Adaptive expectations is the idea that people can change their minds if they notice a repeating pattern from history in the present. Rational expectations is another theory that states that people will make decisions based on three things:

  • Common sense/rationality
  • Individual experiences
  • Information available to them

Unlike adaptive expectations, rational expectations play an active role in affecting the economy. Because people act on their rational expectations, they will do things that influence the economy to meet their expectations.

You can use both terms together in the sense that people will adapt their expectations rationally. But adaptive expectations describe a type of behavior and thinking, whereas rational expectations is a full-blown theory with consequences.