Marketing Thought

Adaptive Market Hypothesis: Evolution And Financial Markets

Andrew Lo has a number of interesting works attempting to link evolutionary thinking and financial markets. See here for his 2006 piece in the Harvard Business Review, entitled Survival of the Richest. Lo shows how evolutionary thinking can be applied to financial markets and explains the idea of the Adaptive Market Hypothesis.

Irrationality And Financial Markets

Lo starts by discussing that: “It’s hard to deny that investors act irrationally from time to time” (Lo, 2006, page 1). I have long argued against this vague use of irrationality by scholars. I think he means the opposite of the traditional assumptions about rationality which he suggests are: “always acting in their own interests and making mathematically optimal decisions” (Lo, 2006, page 1).

Lo says evidence against, i.e., for the irrationality hypothesis, are “…bubbles, crashes, panics, manias and other distinctly unreasonable phenomenon.” Yet it is relatively easy to come up with ways that self-interested optimizing behavior can lead to panics and crashes. I think his logic is a bit loose and falls into familiar problems as people discuss rationality, see here, here, here, and here. Do especially look here where I wonder why we let selfishness be equated with rationality.

The author starts by trying to get the reader on board. He does this by using crude ideas about the nature of rationality. Later we see that he really does not believe these simple ideas. His analysis gets more sophisticated later. For example, he even later uses the term ‘seem irrational’ and puts irrational in quotes. (I worry an editor at HBR may have got a bit excited making this piece ‘popular’ in the early paragraphs and in doing so somewhat undermined Lo’s point).

That said, I wouldn’t want this to take too much from Lo’s idea which is a good one.

Survival Of The Richest In Financial Markets

The Adaptive Market Hypothesis

Lo contrasts those who believe in market efficiency with behavioral economic proponents and argues that neither have it quite right. Behavioral factors surely matter but financial markets, for all their drama, seem to have some sort of underlying logic. (I’m not sure that this makes behavioral economics wrong, but I agree many claiming to be behavioral economists don’t go beyond “look at this weird behavior”.) He suggests the adaptive-markets hypothesis.

This views individual investor behavior as driven by heuristics (rules of thumb). Natural selection works on the behaviors. The rules used change over time with more successful heuristics getting more use. When the world is stable using the traditional rules is relatively effective. But when the world changes the rules that are successful will change. This makes a lot of sense to me.

Using A Heuristic Is Not Irrational

To be clear using heuristics is not evidence of irrationality to my mind. Using heuristics is a reasonable response to a world that is more complex than we can cope with. Again, to be fair I think Lo means this. I am just making what I think he is saying more explicit. He says ‘”rational” and biased become less meaningful qualities than “fit” and adaptable”‘ (Low, 2006, page 2). The very idea of irrationality in markets is not very meaningful.

Lo’s idea is that rules of thumb learned from outside the financial domain generate heuristics brought to the markets. Where the rules do well then they will persist. Interestingly, we will see heuristics rising and falling with the market conditions that favor them. The heuristics are subject to evolutionary pressures themselves.

Financial markets make a lot of sense through the lens of the adaptive markets hypothesis. We can also describe different markets. For example, selection pressure, the punishing of bad heuristics, is likely to be lessened beyond financial markets. I think similar ideas can also apply to other markets.

He finishes talking of survival of the richest. That sounds like a great hook. Still, I am not sure exactly why the phrase was used or what it means. It doesn’t relate clearly to the use of heuristics in markets. Still, it was very catchy.

For more on evolutionary thinking in business strategy see here.

Read: Andrew W. Lo (2006) Survival of the Richest, Harvard Business Review, March 2006

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