An Essay on the Relationship between Andrew Lo’s Adaptive Market Hypothesis and Behavioural Finance

1.0 Introduction

When in 1936, Keynes compared financial markets to a beauty contest where competitors had to guess who the most popular choice would be, he did not imagined that economists would become fascinated with the contest for explaining the efficiency or inefficiency of that market. Indeed, the global financial crisis of 2008 brought to bare the bitter rivalry between traditional finance theorists and their behavioural counterpart over the realism of assumptions explaining competitive market equilibrium, rational choice theory and rational expectations. Prior to the crisis, the dominant view in mainstream economics and finance (as exemplified in the assumptions of efficient market hypothesis) had been that: individuals are broadly rational, risk averse, maximize their expected utility of wealth, and follow the tenets of subjective probability theory. Hence, the capital market is seen as perfect and generating financial returns which are unforecastable. To put it more aptly in the words of Fama (1970), “prices fully reflect all available information”, an idea that has come to be known as market efficiency. However, the fallout from the financial crisis saw a bourgeoning interest in behavioural economics due mainly to the failings of traditional economic theory to explain many observed market anomalies.

Behavioural economists pointed out a number of basic logical mistakes in the efficiency reasoning, which they attributed to behavioural biases and cognitive limitations, which are universal to human decision-making under uncertainty. Some of the documented biases cited in Lo (2004) include overconfidence, loss aversion, overreaction, psychological accounting, herding, miscalibration of probabilities, hyperbolic discounting and regrets. Accordingly, the behaviourists opine that these biases provided evidence that markets are not only inefficient, but that its participants are often irrational. Herein lies the intellectual crux of the debate, which has continue to shape the study and practice of economics and finance. Indeed, while some economists may want to uphold their firm beliefs in market efficiency and rationality, others may as well seek alternative approaches in behavioural finance. Between these two approaches, however, there may be economists who seek for a compromise. This is where Andrew Lo classic work on the adaptive market hypothesis readily falls in.

This essay proceeds as follow; section two explain the Adaptive Markets Hypothesis, its theoretical postulations and relationship with behavioural finance, section three critically examine