Blog - Investing Notes

September 19, 2009 - Have You Reviewed Papers on the Adaptive Market Hypothesis?

A reader asked: "Have you reviewed papers on the Adaptive Market Hypothesis? Andrew Lo of MIT has done much of the academic work. 'The Adaptive Markets Hypothesis: Evidence from the Foreign Exchange Market' is a paper by other authors. A new paper entitled 'A Computational View of Market Efficiency' reviews a lot of the literature and proposes a new framework."

"Survival of the Richest: The Adaptive Markets Hypothesis" summarizes Andrew Lo's original paper on the hypothesis. While abstract, his discussion is intuitively accessible to investors. Occasionally, studies of anomalies check for market adaptation. See, for example, "Beat the Market with Hot-Anomaly Switching?","Performance Trend for Value Line's Timeliness Ranking" and "An Out-of-Sample Test of What Works on Wall Street (O'Shaughnessy's Cornerstone Strategies)".

"A Computational View of Market Efficiency" is abstract and probably difficult for most investors to interpret. Its principal message is:

"In this paper we suggest that a reinterpretation of market efficiency in computational terms might be the key to reconciling this theory with the possibility of making profits based on past prices alone. We believe that it does not make sense to talk about market efficiency without taking into account that market participants have bounded resources. In other words, instead of saying that a market is “efficient” we should say, borrowing from theoretical computer science, that a market is efficient with respect to resources S, e.g., time, memory, etc., if no strategy using resources S can generate a substantial profit. Similarly, we cannot say that investors act optimally given all the available information, but rather they act optimally within their resources. This allows for markets to be efficient for some investors, but not for others; for example, a computationally powerful hedge fund may extract profits from a market which looks very efficient from the point of view of a day-trader who has less resources at his disposal—arguably the status quo."

"The Adaptive Markets Hypothesis: Evidence from the Foreign Exchange Market" examines adaptation within foreign exchange (currently outside the focus of CXOAdvisory.com), as follows:

"We analyze the intertemporal stability of returns to technical trading rules in the foreign exchange market by conducting true, out-of-sample tests on previously published rules. The excess returns of the 1970s and 1980s were genuine and not just the result of data mining. But these profit opportunities had disappeared by the mid-1990s for filter and moving average (MA) rules. Returns to less-studied rules, such as channel, ARIMA, genetic programming and Markov rules, also have declined, but have probably not completely disappeared. The volatility of returns makes it difficult to estimate mean returns precisely. The most likely time for a structural break in the MA and filter rule returns is the early 1990s. These regularities are consistent with the Adaptive Markets Hypothesis (Lo, 2004), but not with the Efficient Markets Hypothesis."