An Intriguing Alternative to the Efficient Capital Markets Hypothesis

According to Andrew Lo's Adaptive Markets Hypothesis (first proposed in 2004), markets are not always efficient.  Although the Efficient Capital Markets Hypothesis or Efficient Markets Hypothesis (EMH) may have applied during the "Great Modulation," identified as "the seven decades spanning the mid-1930s to the mid-2000s in which equity markets exhibited relatively stable risk and expected returns," key assumptions underlying EMH have broken down in the past decade.  Those assumptions include "rational investors, stationary probability laws, and a positive linear relationship between risk and expected return."

Lo proposes the Adaptive Markets Hypothesis (AMH), "an evolutionary perspective on market dynamics in which intelligent but fallible investors learn from and adapt to changing environments. Under the AMH, markets are not always efficient, but they are highly competitive and adaptive, and can vary in their degree of efficiency as the economic environment and investor population change over time. The AMH has several new implications for financial analysis, including the possibility of negative risk premia, the transformation of alpha into beta, and the importance of macro factors and risk budgeting in asset-allocation policies."

Abstract and Article posted on SSRN:  Dec. 30, 2011 

(ag) Jan. 8, 2012, in Economy, Securities, Global Markets