The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective

30TH ANNIVERSARY ISSUE 2004 THE JOURNAL OF PORTFOLIO MANAGEMENT 15 The 30th anniversary of The Journal of Portfolio Management is a milestone in the rich intellectual history of modern finance, firmly establishing the relevance of quantitative models and scientific inquiry in the practice of financial management. One of the most enduring ideas from this intellectual history is the Efficient Markets Hypothesis (EMH), a deceptively simple notion that has become a lightning rod for its disciples and the proponents of behavioral economics and finance. In its purest form, the EMH obviates active portfolio management, calling into question the very motivation for portfolio research. It is only fitting that we revisit this groundbreaking idea after three very successful decades of this Journal. In this article, I review the current state of the controversy surrounding the EMH and propose a new perspective that reconciles the two opposing schools of thought. The proposed reconciliation, which I call the Adaptive Markets Hypothesis (AMH), is based on an evolutionary approach to economic interactions, as well as some recent research in the cognitive neurosciences that has been transforming and revitalizing the intersection of psychology and economics. Although some of these ideas have not yet been fully articulated within a rigorous quantitative framework, long time students of the EMH and seasoned practitioners will no doubt recognize immediately the possibilities generated by this new perspective. Only time will tell whether its potential will be fulfilled. I begin with a brief review of the classic version of the EMH, and then summarize the most significant criticisms leveled against it by psychologists and behavioral economists. I argue that the sources of this controversy can ANDREW W. LO is Harris & Harris Group Professor at the MIT Sloan School of Management, and chief scientific officer at AlphaSimplex Group, LLC, in Cambridge, MA. The Adaptive Markets Hypothesis