The Efficient
Market Hypothesis is one of the most well-known and influential theories in
financial economics. Extensive literature exists on the topic, as many
economists have written about the concept as well as trying to extend upon its
framework. The origins of the theory date back to the 1960’s, nevertheless,
half a century later the concept is still discussed and very highly regarded,
which provides motivation for this essay.

In contrast
to this theory is the Adaptive Market Hypothesis. This idea provides a more
extensive, modern look at the EMH theory. Proposed decades later, the AMH aims
to emerge the EMH concept with behavioural finance ideas to reform the idea that
many individuals have on EMH trading strategy.

In this paper,
I will start by presenting both the EMH and AMH concepts in full. Outlining the
strengths and weaknesses of both. I will then conduct a comparison of the two
concepts to form a decision on which idea seems to be superior – if any.  

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Efficient
Markets Hypothesis (EMH)

As with
many economic theories and ideas of the modern day, the origins of the EMH can
be traced far back. This theory was initially illustrated by Paul Samuelson
(1965). In Samuelson’s paper, “Proof that Properly Anticipated Prices Fluctuate
Randomly”, he adds that in an informationally efficient market, price
fluctuations cannot be foreseen. However, Eugene Fama (1970) formalised this
hypothesis – the theory of EMH generally states that securities markets such as
the stock markets are efficient in pricing, reflecting all publicly available
information. The view was that when new market information arises, the news
quickly spreads, and the market adjusts the security price reflecting the new-found
information without delay. Therefore, neither fundamental analysis or technical
analysis, bear any advantage to investors as these theories are based on
information and if they security price already reflects the information then it
makes them redundant.

Fama (1970)
identified three levels and strengths which explain the efficiency of a market.
These three levels are ‘strong-form’ EMH, ‘semi-strong-form’ EMH and
‘weak-form’ EMH. 

Strong-form
EMH, states that if all relevant information is available to existing and
potential investors and this information is then in turn reflected in the share
price then the market is efficient.  For
example, if the market price is valued lower than it should be, as there is
privately held information, the holders of the private information will exploit
this by buying shares. They will continue to do so until the driving up the
price to which they believe the shares to be worth – supported by the
information. At this point they will sell their shares and withdraw from the
market with a profit. This is an example of strong-form EMH. In theory this is
the most ideal form of EMH for investors. 

The
semi-strong form EMH theory says where all publicly available information is
reflected in the market price a market is efficient. This practically appears
to make more sense of an efficient market. It is thought that markets will
quickly mirror the publication of new information and set a new equilibrium
price. Semi-strong form EMH has practical significance over strong-form EMH as
it can be more practically observed and tested.

Weak-form
EMH is strongly allied with the “Random Walk Theory”. This theory was a term
coined by Burton G. Malkiel, simply put the theory states that securities
prices are completely random therefore are not influenced by any past
events.  The central idea behind this
theory is that the randomness of security prices purifies markets such that
finding price patterns and taking advantage of new information becomes
redundant. Due to this, all known information is fully reflected in prices.
Therefore, uninformed investors can obtain a rate of return similar to returns
achieved by investing experts.

Adaptive
Market Hypothesis (AMH)

The AMH
model, as proposed by Andrew Lo (2004), is an attempt to extend upon on and merge
the EMH model with behavioural economics. The AMH model emphasises the apparent
irrationality of markets as a rational reaction to a change in environmental
conditions. AMH is based on biological evolutions such as competition, learning
and adaptation.

More
generally, the theory is about market conditions being based somewhat on
imperfect individual perceptions of how recent changes may or may not affect
future asset prices. Despite the qualitative nature of this hypothesis, AMH
offers strong implications for the practice of portfolio management, the core
principles of this theory consist of: (1)
individuals act in their own self-interest; (2) individuals make mistakes; (3)
individuals learn and adapt; (4) competition
drives adaptation and innovation; (5) natural
selection shapes market ecology; (6) evolution
determines market dynamics1

It is
implied that the market efficiency is based on evolutionary principles and
environmental factors such as the number of competitors in a market and the
able of market participants to adapt to the market conditions. According to Lo
(2004) the AMH can be viewed as an alternative to EMH, derived from
evolutionary principles.

Under the
AMH investment strategies will be cycle through periods of profits and losses
as a result of changing market conditions, changing number of competitors entering
and exiting the market and the extent of profitable opportunities. As these
opportunities change, so do the affected populations. The AMH has specific
implications. The first is that opposed to EMH, there are few arbitrage
opportunities, as the absence of these opportunities would leave no incentive
to gather information on security prices. However, as investors use these
opportunities they disappear.

1
Lo, Andrew W. Ph. D. (2005), RECONCILING EFFICIENT MARKETS WITH BEHAVIORAL
FINANCE: THE ADAPTIVE MARKETS HYPOTHESIS, VOL. 7, NO. 2. 

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