michael chan john hautzinger constance jiang. introduction efficient markets hypothesis (emh)...
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IntroductionEfficient Markets Hypothesis (EMH)Propose new framework, Adaptive Markets
Hypothesis (AMH), reconciling EMH with behavioral biases
Efficient Markets HypothesisThe notion that markets fully, accurately, and
instantaneously incorporate all available information into market pricesParticipants are rational beings always making
optimal choices in self-interestPsychologists and experimental economists
have documented behavioral biases that do not follow market rationalityEMH criticizes behavior as observations
without principles to explain the origin
Experiments - overconfidenceRusso & Shoemaker (1989) – subjects asked
to give 90% confidence answers(ranges) in response to questions w/numerical answersSubjects should be wrong only 10% of the timeResults: < 1% of the subjects scored 9/10.
Most missed 4-7 questions.Most individuals are more confident of their
knowledge than is warranted
Experiments – reliance on representativesTversky and Kahneman (1982) proposed a
question to subjects and asked them to pick the more likely answerLinda is 31 years old, single, outspoken, and
very bright. She majored in philosophy. As a student, she was deeply concerned w/ issues of discrimination & social justice, & participated in anti-nuclear demonstrations. Check the more likely alternative Linda is a bank teller Linda is a bank teller and is active in the feminist
movement.
Experiments – behavioral biasKahneman & Tversky (1979) - 2 investment
opportunities, A & B:A yields sure profit of $240kB yields $1mil w/25% probability & $0 w/75%
probabilityC & D:
C yields sure loss of $750kD yields $0 w/25% probability & $1mil loss
w/75% probability
Experiments – behavioral bias(contd)A&D equivalent to:
25% chance of $240k yield, 75% chance of $760k loss
B&C equivalent to:25% chance of $250k yield, 75% chance of
$750k lossB&C has $10k higher gain, $10k lower loss
Neuroscience PerspectiveParts of the brain: brain stem, limbic system,
cerebral cortexPhysiological adaptations geared towards
survivalHumans adapt to fit environmental conditions
[Investment] preferences may change as wellCompetitiveness of global financial markets
suggests Darwinian selection is also applicableUnsuccessful market participants are eliminated
after suffering certain losses
AMH - Adaptive Markets Hypothesis
Uses a Darwinian perspectivefinancial markets = ecosystem dealers = herbivoresspeculators = carnivoresfloor traders and distressed investors =
decomposers
Adaptive Markets Hypothesis“Satsificing“
Due to limited computational abilitiesMaking choices to meet satisfactory standards.
How to determine what's satisfactory? Pos/Neg reinforcement leads to learning.When economic challenges stabilize, there's your
optimal solution.
Change of environmentBecome "maladaptive," fish out of water
Adaptive Markets HypothesisAMH - the new EMH
(A1) Individuals act in their own self-interest.(A2) Individuals make mistakes.(A3) Individuals learn and adapt.(A4) Competition drives adaptation and
innovation.(A5) Natural selection shapes market ecology.(A6) Evolution determines market dynamics.
Adaptive Markets HypothesisEverything converges to equilibrium
Competition increaseResource depletedDecline in populationLess competitionSometimes permanent loss of resource or
extinction of species
Role of the ConsultantAssists managers and investors in dealing with
preferences.1. Educate investors and managers2. Assist in examine/modifying risk preferences3. Matching investor and manager's
perferences
Role of the ConsultantSensitive to changing markets.
Familiar with a wide spectrum of investment products and services
Must continually seek education.Financial technologyAdvances in neuroscienceTraining and certification programs
ApplicationsProblemsStill in its infancy
Much research must be done to establish viability
However, questions arise about the relevancy of AMH compared to previously established EMHA wealth of tools exist for EMHEMHs have a long history
Preferences MatterIndividual preferences have long been
studied in a variety of pitfallsCare must be taken to avoid pitfalls
Pitfalls must first be known in order to avoid them
Each industry focuses on a different aspect of decision makingPsychological surveys are designed to capture
broad characteristics of personalityEconomists perform choice experimentsMarket Researchers conduct field studies of
consumer preferences
Advances in Studying Decision MakingNueroscience
Decisions are interactions between specialized parts of the brain
Use of a combination of survey techniques must be used to achieve desired results
Work must be done with investors on an individual basisIn order to help articulate and accurately
represent the final goals of the individual
Revisiting Asset AllocationAnother facet of the AMH framework
Selection of portfolio weights for broad asset classes
Relation between risk and rewardNever stable over time
Insights from AMHAggregate risk preferences are constantly
being shaped and reshaped over timeNatural selection process
Contrary to EMH arbitrage do exist from time to timeAs profit opportunities come to light, they are
exploited and disappearNew opportunities appear as older
opportunities die out
Insights from AMH(Cont.)Like profit opportunities, investment
strategies wax and waneUnlike EMH in which opportunities are
competed away, AMH allows for the assumption that opportunities may decline, but will return
Example: Risk Arbitrage Became unprofitable in the decline of 2001 As pace mergers and acquisitions increase, risk
arbitrage will come back to profitability
Insights from AMH(Cont.)Value and growth may behave like risk
factors from time to timePortfolios with such characteristics may yield
higher returns than periods when those factors are favorable
Bottom Line Regarding Active Asset Allocation Policies may only be right for certain people
under certain market conditionsAMH does not imply active asset allocation is
any less difficultProvides a rationale for the apparent cyclical
nature of risk factors and points the way to promising new research directions
Dynamics of Competition and Market EcologyAnother key application of the AMH
framework to investment management is the insight that innovation is the key to survivalEMH suggests that certain levels of expected
returns can be achieved simply by bearing a sufficient degree of risk.
AMH implies that the risk/reward relation varies through time and that a better way of achieving a consistent level of expected returns is to adapt to changing market conditions
For ConsiderationAsk where the next financial asteroid will
come fromThe AMH has a clear implication for all
financial market participants Survival is ultimately the only objective that matters Profit maximization, utility maximization, and
general equilibrium are certainly relevant aspects of market ecology
The organizing principle in determining the evolution of markets and financial technology is simply survival.
InnovationKey to AMH Framework
Takes on an urgency generally missing from most financial decision making paradigms EMH Modern portfolio theory Capital Asset Pricing Model (CAPM)
Role of Adaptive Markets in Machine LearningAdaptive markets imply an every changing,
however somewhat cyclical marketplacePerfect for machine learningIf truly cyclical then machine learning could
use known parameters to predict outcomes in the short and long term
ML allows for consideration of all aspects of the decision process