How Adaptive Market Hypothesis Works

The concept of adaptive market hypothesis states that companies make it difficult to buy underpriced stocks. Companies sell their stocks at an overpriced rate, meaning they always transact at fair value, making it impossible to defeat the stock market. However, when behavioral finance came into place, it attempted to defeat the theory of adaptive market hypothesis.

Expert analysts like Eugene Fama theorized that investors are tagged as irrational and incompetent only because they do not always transact at fair value. It is especially so when the stock market is volatile or when it crashes. According to the founder of the adaptive market hypothesis, even though many believe that most people are rational, they can easily become irrational. It usually happens when it comes to market volatility that creates buying opportunities.

It means that investors can be rational or irrational depending on the current situation of the market. Behaviors of most investors such as overconfidence, fear of loss, or impulse are related to the evolutionary characteristics of humans. It includes natural selection, adaptation, and competition. Most people are used to making future decisions based on past experiences and constantly learn from their mistakes or the results of a bad decision. Because most humans use trial and error, if one strategy doesn't work for an investor, they instantly look for another.

Example of Adaptive Market Hypothesis

Miley, an investor, has decided to buy stocks in large quantities when the prices are moderately high. She is only doing so because she has learned to build and manage a stock portfolio from previous experience.

It is not the best strategy for Miley to follow regarding the nature of the market. However, she does so because there are many good reasons for that strategy, and it is a popular form of adaption.

During this time, many investors will take advantage of the current nature of the market by purchasing stocks. They do this with the assumption that the price of the stocks won't decrease since it hasn't done so previously. However, the market changed, and the price of the stocks fell, resulting in losses for investors like Miley.

Significance of Adaptive Market Hypothesis

The adaptive market hypothesis aims to use different theories to show how investor and market behavior works. It further indicates that both rationality and irrationality exist while using evolution and behavior and financial dealings.

It identifies a significant flaw in investors because they judge future happenings in the stock market based on past incidents and experiences. It also explains why their self-interest inspires people. Adaptive market hypothesis details why people always make mistakes in their choices. And it explores how people live with and learn from the mistakes they make.

Adaptive Market Hypothesis vs. Efficient Market Hypothesis

Even though the definition includes an efficient market hypothesis in the adaptive market hypothesis, they are not the same. That is because the efficient market hypothesis talks about how investors are rational and efficient. In comparison, the adaptive market hypothesis states that investors are both rational and irrational depending on the circumstances or current nature of the market at that moment.

Humans use their evolutionary characteristics, behavior, and past market happenings to make financial decisions regarding the stock market. The aim of the efficient market hypothesis postulated by Eugene Fama is to show that investors can't defeat the market because companies transact at fair value. It also explains that underpriced stocks can't be purchased or sold at an overpriced rate. It further shows that before an investor makes any financial move, they consider the pros and cons of the decision because the investor is rational, competent, and efficient.

History of the Adaptive Market Hypothesis

The economic theory called the adaptive market hypothesis was first postulated in 2004 by Andrew Lo, a Massachusetts Institute of Technology professor. The adaptive market hypothesis aims to combine both the efficient market hypothesis, which says that investors are rational and competent and behavioral finance, which states that investors are entirely irrational and incompetent.