Adaptive Investment Approach

During the last decade, we have experienced two deep bear markets as results of internet bubble burst and mortgage crisis. Many investors suffered significant losses and found it hard to achieve their investment goals. The traditional investment theory such as mean-variance portfolio theory and Efficient Market Hypothesis (EMH), and associated practices such as buy-and-hold, or benchmark-centric investments have proved inadequate in helping investors achieve their financial goals. Market participants are now questioning the broad theoretical framework and looking for alternative way to made better investment decisions. As an alternative, the Adaptive Markets Hypothesis (AMH), proposed by Lo (2004, 2005, 2012), in which intelligent but fallible investors constantly adapt to changing market conditions, helps explain the importance of macro factors and market sentiment in driving asset returns. It allows for evolution towards market efficiency and a dynamic and adaptive approach to investing, which may serve investors better in the everchanging financial markets. In this paper, I will address some of the shortcomings of modern portfolio theory and Efficiency Market Hypothesis as well as the drawbacks in their application. More importantly, I will introduce a framework of adaptive investment, in which investors try to find the best investment opportunities by adapting constantly to changing economic and market conditions. In its simplest form, in a risk-seeking (“risk on”) environment, investors allocate their portfolios to risk assets such as equities, commodities, real estate and high yield bonds; in a risk-avoidance (“risk off”) environment, investors flight to safety by allocating portfolios to Treasuries and cash. Although there are numerous ways to define and estimate market regimes and environment, this type of strategies aim to deliver consistent returns by adapting a portfolio to constantly changing market conditions. This approach differs from absolute return strategy in that it generates returns through market betas rather uncorrelated alpha, though it aims to provide consistent returns regardless of market conditions. It also differs from traditional beta investments because it does not follow any particular benchmark. Adaptive investment has some