The Committee of Public Safety

Adaptive Market

The incumbent theory: the Efficient Market Hypothesis (EMH):

[T]he notion that markets fully, accurately, and instantaneously incorporate all available information into market prices. Underlying this far-reaching idea is the assumption that market participants are rational economic beings, always acting in self-interest and making optimal decisions by trading off costs and benefits weighted by statistically correct probabilities and marginal utilities.

A challenger: the Adaptive Market Hypothesis (AMH):

[T]he AMH can be viewed as a new version of the EMH, derived from evolutionary principles. The primary components of the AMH consist of the following ideas:

• (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.

EMH and AMH have a common starting point in A1, but the two paradigms part company in A2 and A3. In efficient markets, investors do not make mistakes, nor is there any learning and adaptation because the market environment is stationary and always in equilibrium. In the AMH framework, mistakes occur frequently, but individuals are capable of learning from mistakes and adapting their behavior accordingly. However, A4 states that adaptation does not occur independently of market forces but is driven by competition, that is, the push for survival. The interactions among various market participants are governed by natural selection—the survival of the richest, in our context—and A5 implies that the current market environment is a product of this selection process. A6 states that the sum total of these components—selfish individuals, competition, adaptation, natural selection, and environmental conditions— is what we observe as market dynamics.

AMH attempts to bridge the widening gap between EMH proponents and behavioral economics proponents. Work in behavioral economics has exposed the following anomalies in economic behavior:

• Heuristics: people often make decisions based on approximate rules of thumb, not on strictly rational analysis.
• Framing: the way a problem or decision is presented to the decision maker will affect their action.
• Market inefficiencies: there are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies.

The AMH follows sociobiology in applying natural selection to more than biology:

Contrary to the neoclassical postulate that individuals maximize expected utility and have rational expectations, an evolutionary perspective makes considerably more modest claims, viewing individuals as organisms that have been honed—through generations of natural selection—to maximize the survival of their genetic material. This perspective implies that behavior is not necessarily intrinsic and exogenous but evolves by natural selection and depends on the particular environment through which selection occurs. That is, natural selection operates not only upon genetic material, but upon biology and also social behavior and cultural norms in Homo sapiens.

The most interesting aspect of this theory is its exposition of the lag between biological adaptation to a prior environment and the current human environment:

The proper response to the question of how individuals determine the point at which their optimizing behavior is satisfactory is this: Such points are determined not analytically, but through trial and error and, of course, natural selection. Individuals make choices based on experience and their best guesses as to what might be optimal, and they learn by receiving positive or negative reinforcement from the outcomes. If they receive no such reinforcement, they do not learn. In this fashion, individuals develop heuristics to solve various economic challenges, and as long as those challenges remain stable, the heuristics eventually will adapt to yield approximately optimal solutions.

If, on the other hand, the environment changes, then it should come as no surprise that the heuristics of the old environment are not necessarily suited to the new. In such cases, we observe behavioral biases—actions that are apparently ill advised in the context in which we observe them. But rather than labeling such behavior irrational, we should recognize that suboptimal behavior is likely when we take heuristics out of their evolutionary context. A more accurate term for such behavior might be “maladaptive.” The flopping of a fish on dry land may seem strange and unproductive, but under water, the same motions propel the fish away from its predators. And the antagonistic effect of human emotional reactions on logical reasoning described earlier is maladaptive for many financial contexts.

This lag was also discussed extensively by Nassim Nicholas Taleb in The Black Swan. Taleb’s example is the simple heuristic of seeing a leopard and turning and running. The environment of our primitive hunter-gatherer ancestors rewarded this as a high return activity: running at the sight of a leopard enhanced survivability. However, the same instincts are counter-productive and low return when you turn to the current environment. The urge to panic when the market is crashing could drive you to exit the market at the wrong time. Fight or flight isn’t an appropriate evaluation framework under all conditions.

However, this idea of adaptive lag has applications to problems of adaption overall. A specific example of lag that the AMH paper discusses is the structure of the triune brain:

The starting point is a basic fact about the brain: it is not a homogeneous mass of nerve cells but a collection of specialized components, many of which have been identified with particular functions and types of behavior. For example, the brainstem, which is located at the base of the brain and sits on top of the spinal cord, controls the most basic bodily functions such as breathing and heartbeat and is active even during deep sleep. The limbic system, which comprises several regions in the middle of the brain, is responsible for emotions, instincts, and social behavior such as feeding, fight-or-flight responses, and sexuality. And the cerebral cortex, which is the tangled maze of gray matter that forms the outer layer of the brain, is what allows us to think complex and abstract thoughts and where language and musical abilities, logical reasoning, learning, long-term planning, and sentience reside. These three areas form the triune brain model, proposed by MacLean; he refers to them as the reptilian, mammalian, and hominid brains, respectively. This terminology underscores his hypothesis that the human brain is the outcome of an evolutionary process in which basic survival functions appeared first, more advanced social behavior came second, and uniquely human cognitive abilities emerged most recently (that is, within the past 100,000 years).

From this we can postulate three biological OODA loops within the human brain, each one with ever shorter lags in adaptation:

1. The reptilian loop
2. The mammalian loop
3. The hominid loop

If we follow the momentum of AMH and take the logic of evolution into less biologically hardwired human “software”, we can see five OODA loops and the steadily decreasing lag between each:

1. The cultural loop
2. The political loop
3. The strategic loop
4. The operational loop
5. The tactical loop

Much of the adaptation mismatches that occur in human political communities and individuals can be traced to adaptive lag. A particular loop is optimized for a specific environment and acquires optimizations peculiar to that environment. However, the environment changes and loops with slower lag times adapt at a sometimes glacial pace. Within the “software” portion of the human brain, culture is the slowest to adapt, followed by politics, and strategy. This is not to say rapid adaption in software can’t happen at these higher levels like culture, only that, on average, adaption will be slower than the lowest levels.

As the AMH argues, systemic human irrationality is not necessarily globally irrational as it is locally irrational. Many adaptations such as heuristics and cognitive biases make sense in a legacy adaption context but make less sense in a contemporary adaption context. They are rational under the right circumstances but irrational under other circumstances. Similarly, the software stack of adaptation contains rationalities under some contexts but irrationalities under other contexts. The true measure of adaptive capacities is how rapidly irrationalities can be replaced with rationalities. Since some irrationalities are bound up in emotion and power distributions, this isn’t always easy. On the other hand, some adaptions which seem irrational to a “rational” observer and that are done away with turn out to have been rational after all. The end result is a stack of OODA loops that contain a mix of rationality and irrationality and lag behind the adaption curve on average.

Whether the AMH claims that evolution produces the same global omniscience that the EMH claims that markets attain is an open question. If the current state of the myriad OODA loops of the contemporary world constitute adaptive market omniscience, then the life of man is truly Hobbesian, solitary, poor, nasty, brutish, and short. Here’s to an imperfect, inefficient market.