Transcript AMH
Michael Chan
John Hautzinger
Constance Jiang
Introduction
Efficient Markets Hypothesis (EMH)
Propose new framework, Adaptive Markets Hypothesis
(AMH), reconciling EMH with behavioral biases
Efficient Markets Hypothesis
The notion that markets fully, accurately, and
instantaneously incorporate all available information
into market prices
Participants are rational beings always making optimal
choices in self-interest
Psychologists and experimental economists have
documented behavioral biases that do not follow
market rationality
EMH criticizes behavior as observations without
principles to explain the origin
Experiments - overconfidence
Russo & Shoemaker (1989) – subjects asked to give
90% confidence answers(ranges) in response to
questions w/numerical answers
Subjects should be wrong only 10% of the time
Results: < 1% of the subjects scored 9/10. Most missed 4-
7 questions.
Most individuals are more confident of their
knowledge than is warranted
Experiments – reliance on
representatives
Tversky and Kahneman (1982) proposed a question to
subjects and asked them to pick the more likely
answer
Linda is 31 years old, single, outspoken, and very bright.
She majored in philosophy. As a student, she was deeply
concerned w/ issues of discrimination & social justice, &
participated in anti-nuclear demonstrations. Check the
more likely alternative
Linda is a bank teller
Linda is a bank teller and is active in the feminist movement.
Experiments – behavioral bias
Kahneman & Tversky (1979) - 2 investment
opportunities, A & B:
A yields sure profit of $240k
B yields $1mil w/25% probability & $0 w/75% probability
C & D:
C yields sure loss of $750k
D yields $0 w/25% probability & $1mil loss w/75%
probability
Experiments – behavioral
bias(contd)
A&D equivalent to:
25% chance of $240k yield, 75% chance of $760k loss
B&C equivalent to:
25% chance of $250k yield, 75% chance of $750k loss
B&C has $10k higher gain, $10k lower loss
Neuroscience Perspective
Parts of the brain: brain stem, limbic system, cerebral
cortex
Physiological adaptations geared towards survival
Humans adapt to fit environmental conditions
[Investment] preferences may change as well
Competitiveness of global financial markets suggests
Darwinian selection is also applicable
Unsuccessful market participants are eliminated after
suffering certain losses
AMH - Adaptive Markets
Hypothesis
Uses a Darwinian perspective
financial markets = ecosystem
dealers = herbivores
speculators = carnivores
floor traders and distressed investors = decomposers
Adaptive Markets Hypothesis
“Satsificing“
Due to limited computational abilities
Making choices to meet satisfactory standards.
How to determine what's satisfactory?
Pos/Neg reinforcement leads to learning.
When economic challenges stabilize, there's your optimal
solution.
Change of environment
Become "maladaptive," fish out of water
Adaptive Markets Hypothesis
AMH - the new EMH
(A1) Individuals act in their own self-interest.
(A2) Individuals make mistakes.
(A3) Individuals learn and adapt.
(A4) Competition drives adaptation and innovation.
(A5) Natural selection shapes market ecology.
(A6) Evolution determines market dynamics.
Adaptive Markets Hypothesis
Everything converges to equilibrium
Competition increase
Resource depleted
Decline in population
Less competition
Sometimes permanent loss of resource or extinction of
species
Role of the Consultant
Assists managers and investors in dealing with
preferences.
1.
2.
3.
Educate investors and managers
Assist in examine/modifying risk preferences
Matching investor and manager's perferences
Role of the Consultant
Sensitive to changing markets.
Familiar with a wide spectrum of investment products
and services
Must continually seek education.
Financial technology
Advances in neuroscience
Training and certification programs
Applications
Problems
Still in its infancy
Much research must be done to establish viability
However, questions arise about the relevancy of AMH
compared to previously established EMH
A wealth of tools exist for EMH
EMHs have a long history
Preferences Matter
Individual preferences have long been studied in a
variety of pitfalls
Care must be taken to avoid pitfalls
Pitfalls must first be known in order to avoid them
Each industry focuses on a different aspect of decision
making
Psychological surveys are designed to capture broad
characteristics of personality
Economists perform choice experiments
Market Researchers conduct field studies of consumer
preferences
Advances in Studying Decision
Making
Nueroscience
Decisions are interactions between specialized parts of
the brain
Use of a combination of survey techniques must be used
to achieve desired results
Work must be done with investors on an individual
basis
In order to help articulate and accurately represent the
final goals of the individual
Revisiting Asset Allocation
Another facet of the AMH framework
Selection of portfolio weights for broad asset classes
Relation between risk and reward
Never stable over time
Insights from AMH
Aggregate risk preferences are constantly being shaped
and reshaped over time
Natural selection process
Contrary to EMH arbitrage do exist from time to time
As profit opportunities come to light, they are exploited
and disappear
New opportunities appear as older opportunities die out
Insights from AMH
(Cont.)
Like profit opportunities, investment strategies wax
and wane
Unlike EMH in which opportunities are competed away,
AMH allows for the assumption that opportunities may
decline, but will return
Example: Risk Arbitrage
Became unprofitable in the decline of 2001
As pace mergers and acquisitions increase, risk arbitrage will
come back to profitability
Insights from AMH
(Cont.)
Value and growth may behave like risk factors from
time to time
Portfolios with such characteristics may yield higher
returns than periods when those factors are favorable
Bottom Line Regarding
Active Asset Allocation
Policies may only be right for certain people under
certain market conditions
AMH does not imply active asset allocation is any less
difficult
Provides a rationale for the apparent cyclical nature of
risk factors and points the way to promising new
research directions
Dynamics of Competition
and Market Ecology
Another key application of the AMH framework to
investment management is the insight that innovation
is the key to survival
EMH suggests that certain levels of expected returns can
be achieved simply by bearing a sufficient degree of risk.
AMH implies that the risk/reward relation varies
through time and that a better way of achieving a
consistent level of expected returns is to adapt to
changing market conditions
For Consideration
Ask where the next financial asteroid will come from
The AMH has a clear implication for all financial market
participants
Survival is ultimately the only objective that matters
Profit maximization, utility maximization, and general
equilibrium are certainly relevant aspects of market ecology
The organizing principle in determining the evolution of
markets and financial technology is simply survival.
Innovation
Key to AMH Framework
Takes on an urgency generally missing from most
financial decision making paradigms
EMH
Modern portfolio theory
Capital Asset Pricing Model (CAPM)
Role of Adaptive Markets
in Machine Learning
Adaptive markets imply an every changing, however
somewhat cyclical marketplace
Perfect for machine learning
If truly cyclical then machine learning could use known
parameters to predict outcomes in the short and long
term
ML allows for consideration of all aspects of the decision
process