The Adaptive Markets Hypothesis: A Step In The Right Direction

Dr. Lo’s Adaptive Market Hypothesis attempts to address behavior.  Here is his “adaptive” approach to the above five principles.

The Five Principles of the Traditional Investment Paradigm
from the Perspective of Adaptive Markets

Principle 1A:  The Risk/Reward Trade-Off.  During normal market conditions, there’s a positive association between risk and reward among all financial investments.  However, when the population of investors is dominated by individuals facing extreme financial threats, they can act in concert and irrationally, in which case risk will be punished.  These periods can last for months or, in extreme cases, for decades.

Principle 2A:  Alpha, Beta, and the CAPM.  The CAPM and related linear factor models are useful inputs for portfolio management, but they rely on several key economic and statistical assumptions that may be poor approximations in certain market environments.  Knowing the environment and population dynamics of market participants may be more important than any single factor model.

Principle 3A:  Portfolio Optimization and Passive Investing.  Portfolio optimization tools are only useful if the assumptions of stationarity and rationality are good approximations to reality.  The notion of passive investing is changing due to technological advances, and risk management should be a higher priority, even for passive index funds.

Principle 4A:  Asset Allocation.  The boundaries between asset classes are becoming blurred, as macro factors and new financial institutions create links and contagion across previously unrelated assets.  Managing risk through asset allocation is no longer as effective today as it was during the Great Modulation.

Principle 5A:  Stocks for the Long Run.  Equities do offer attractive returns over the very long run, but few investors can afford to wait it out.  Over more realistic investment horizons, the chances of loss are significantly greater, so investors need to be more proactive about managing their risk.

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Disclosure: Anderson Griggs & Company, Inc., doing business as Anderson Griggs Investments, is a registered investment adviser.  Anderson Griggs only conducts business in states and ...

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