Entry Date:
March 12, 2015

Foundations of Financial Behavior and Adaptive Markets

Principal Investigator Andrew Lo


Modern investment theory and practice is largely based on the Efficient Markets Hypothesis (EMH), which asserts that financial markets fully, accurately, and instantly incorporate all available information into market prices. However, underlying this idea is the assumption that market participants are rational beings. While this may be true most of the time, periods of booms, busts, and financial crises tell us that this isn’t always the case.

The Adaptive Markets Hypothesis (AMH) is an interdisciplinary approach to reconciling the EMH with human behavior. The AMH posits that the impact of evolutionary forces such as competition, mutation, reproduction, and natural selection on financial institutions and market participants determines the efficiency of markets and the waxing/waning of investment products, businesses, industries, and ultimately institutional and individual wealth. Further, it implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of market participants. In this light, the EMH isn’t wrong, it’s simply incomplete.