Adaptive Markets summary

You might be thinking, if the Efficient Market Hypothesis is so accurate and simple, why do huge financial crises where assets are grossly misvalued, like the one in 2008, keep happening?

The answer to this question has to do with human nature and the fact that those in control of the market are prone to making decisions based on irrational emotions. So, even if a company is by all accounts healthy, if the price of its stock takes a momentary dip, this can trigger a panicked response among traders worried about losing too much money and, in turn, will cause them to sell. This is known as behavioral economics.

One of the limitations of the Efficient Market Hypothesis is that it assumes the rational investors will outweigh the impact of irrational investors. Even if we all agree that humans are bound to make mistakes and use poor judgment, the question remains: how adversely can these behaviors affect the market?

First of all, it helps to understand just how irrational humans are when it comes to taking risks, determining probability and making financial decisions.

So, what is it exactly that makes us so prone to reckless and irrational decisions when dealing with money?

Neuroscience suggests that the answer lies in how inextricably linked our decision making is to the emotional part of our brain.

You’ve heard the phrase, “survival of the fittest,” right? It’s a simplification of Darwin’s theory of natural selection, which states that only those with optimal traits will survive within certain species and environments, and over time, we will see these traits become more dominant.

As the Adaptive Market Hypothesis shows us, economies function in much the same way, and it’s the regulators, investors, insurance companies and hedge funds that are trying to survive.

As we saw in the previous blinks, when the efficient market is working properly, all stock prices accurately reflect their true value. This is known as a state of equilibrium.

According to the Efficient Market Hypothesis, prices tend to fluctuate from time to time, but the market will eventually return to equilibrium. And this is why long-term investments make sense, as they allow you to wait out the fluctuations, safe in the knowledge that it’s just a matter of time before your investments attain their true worth.

Following the 2008 financial crisis, when investors were faced with the tough decision of how to react, many of them started casting blame and looking for explanations. So what happened?

Most financial crises are an example of what happens when a market changes faster than investors can adapt.

If the Adaptive Market Hypothesis can help us see what went wrong in 2008, can it perhaps also point us to a better way forward, with more reliable markets?

What history tells us is that we need better legislation to help prevent greed and fear-based decisions from ruining and damaging our economy.