Reconciling Ecient Markets with Behavioral Finance: The Adaptive Markets Hypothesis

The battle between proponents of the Ecient Markets Hypothesis and champions of be-havioral nance has never been more pitched, and there is little consensus as to which side is winning or what the implications are for investment management and consulting. In this ar-ticle, I review the case for and against the Ecient Markets Hypothesis, and describe a new framework|the Adaptive Markets Hypothesis|in which the traditional models of modern nancial economics can co-exist alongside behavioral models in an intellectually consistent manner. Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market eciency is related to environmental factors characterizing market ecol-ogy such as the number of competitors in the market, the magnitude of prot opportunities available, and the adaptability of the market participants. Many of the examples that be-havioralists cite as violations of rationality that are inconsistent with market eciency|loss aversion, overcondence, overreaction, mental accounting, and other behavioral biases|are, in fact, consistent with an evolutionary model of individuals adapting to a changing envi-ronment via simple heuristics. Despite the qualitative nature of this new paradigm, I show that the Adaptive Markets Hypothesis yields a number of surprisingly concrete applications for both investment managers and consultants. The views and opinions expressed in this article are those of the author only, and do not necessarily rep-resent the views and opinions of AlphaSimplex Group, the Investment Management Consultants Association (IMCA), MIT, or any of their aliates and employees. The author make no representations or warranty, either expressed or implied, as to the accuracy or completeness of the information contained in this article, nor is he recommending that this article serve as the basis for any investment decision. This article is fo