Rational and Irrational Behavior

Implications of Effective Market Hypothesis and Adaptive Market Hypothesis

Introduction
In 2015, actively managed equity funds suffered the net outflow of 124
billion dollars while exchange traded funds took 200 billion dollars (Robin, 2016).
According to the Financial Times, the deterioration of active managers performance
further calls the justification on higher fees and their efficiency in asset management
into question (Robin, 2016). About 10 percent of actively large-cap funds
outperformed, and 90 percent fell below the benchmark. With respect to performance
persistence, only a low single-digit share of funds remained in the top performing
quartile and only 42 percent of professional investors attributed outperformance to
superior skill according to the State Streets survey (John, 2014).
So is active management doomed to fail? Is it a losing game against the tide
of market? Addressing such questions would require assessments of financial markets
through established or establishing academic theories and empirical evidence.
Conventional and dominant academic theory, Efficient Market Hypothesis (hereafter
EMH) offers concrete and positive view whereas newly formulating Adaptive Market
Hypothesis (hereafter AMH) invites behavioral approach to address financial market.
Their own interpretation of market and abnormal profits might offer some insights to
either or heuristic or rational investors.
Justified fleeing of asset to passive management under dominant EMH but AMH
suggests the need of more flexible perspective and assessment of active management.
Review of each Hypothesis and possible response of investors in the situation.
Examination of EMH through explanation of the hypothesis and testing for
existing anomalies. A new evolutionary approach to examine the market and
possible implications and critcs against it. At last, it draws the conclusion
regarding the active asset management field.
Discern the market behavior
Evaluating
Rational Behavior: Efficient Market Hypothesis
EMH is grounded on the traditional belief that individuals are rational. It
originates from the Samuelsons article proof that properly anticipated Prices
Fluctuate Randomly (Urquhart, 2013). The article claims that the market incorporates
available information and expectations. The pricing of securities are determined by
the expectations of participants who forecast firms future performances with
available information. The current price is thus the incorporation of participants
rational expectations (Fama, 1970, Campbell, 1997)..
Consequently, the future price depends on unannounced and random news
since the information currently available is priced in by the expectations of rational
participants. The movement of future price is thus random; markets fully aggregate
information [], and equilibrium prices incorporate all available information
(Fama, 1970, Campbell, 1997). Upon the arrival of new information, the
opportunities for abnormal profit are created since market participants have not
possibly expected the random news. Participants take account of new information
and correct their expectations and the prices of securities; the market again fully
incorporates available information quickly (Fama, 1970).
In order to create such an efficient and rational market, Shleifer outlines 4
assumptions that market needs: investors rationality, arbitrage, collective rationality,
and costless information and trades (Shleifer, 2000)

Investors rationality guarantees that the investors valuation of securities will

be readily and logically corrected and updated upon new information. Under this
assumption, investors value securities with available information and once their
information with which they valued securities is no longer valid, they reflect their
valuation upon new information. Once the price is not in its equilibrium, altered by
either misperception of investors or new information, arbitraging facilitates the
movement of price towards the equilibrium. Investors readily take advantage of
additional profit, and thus the capacity of arbitraging quickly removes inefficient
market price (Shleifer 2000).
Once market operates under collective rationality, any errors likely to create
inefficiency in pricing will be also randomly eliminated by the other side of random
errors. Largely efficient market, of course, may contain few irrational participants.
However, the random error made by irrational participants will be canceled out by the
market without affecting the equilibrium price (Shleifer, 2000)
To enable investors logically evaluate securities and bring equilibrium in
market, there should be no discrimination in accessing on information and no
transaction cost. Under asymmetric information, investors will be able to act on
information unavailable to other investors which will alter the equilibrium price and
will achieve abnormal profits (Shleifer, 2000)
Efficient market according to Fama takes 3 different forms which are defined
by employing different levels of information. Weak form states that information on
past stock prices is publicly available. Any past trend of prices that might suggest the
future trend is already available to investors. Investors readily take account of the past
movement pattern of prices if it carries any significance to the measure of future
price.
Therefore, the market is in weak form of efficiency and investors will not be able to
obtain abnormal profit from technical analysis: analysis of the past price movement.
(Fama, 1970)
Semi-strong form asserts that information including the stock price trend and
publicly available fundamentals of companies, i.e. product line, quality of
management, balance sheet composition, patents held, earning forecasts, and
accounting practices, are priced in (Urquhart, 2013). Investors rationally build up the
expectation of future performance of a company based on available fundamentals.
The prices of securities reflect both expectation of future performance of companies
and the past stock price trends. Thus, fundamental analysis in addition to technical
analysis will not yield abnormal profits (Fama, 1970).
Strong Form implies that all information including the inside information of a
company is reflected in its stock price. Inside information of a company includes not
publicized material information such as its plan to merge with competitors, and its
current product line performance, market share, and related costs. Not publicized
material information which would alter investors valuation on its securities is already
priced in for the current price. Under this strongest form of efficiency, even insider
who obtains relevant and material information before the market cannot obtain
abnormal profit (Fama, 1970).
EMH, in whatever form it takes, suggests that rational participants readily
interact and bring the market to efficiency. Under efficient market, rational
participants instantaneously price in upon new information and the equilibrium price
will reflect any relevant information. Thus, participants will not be able to
systematically exploit the market for abnormal profit with transaction costs (Jensen,
1978).

Abnormal Return under Efficient Market Hypothesis

An abnormal profit with EMH would occur if the market either follows EMH
in theoretical weak or semi-strong forms or provides anomalies indicating failures of
EMH at times. In theoretical frame, persistent abnormal profit - or positive risk
adjusted-return - is achievable depending on its form of efficiency. Though the degree
of information needed for abnormal profit varies by the forms of market efficiency,
active managers are able to beat the benchmark by employing specific strategies
based on information not priced in for the market.
Theoretically, obtaining abnormal profit needs information involving 3 forms
of market efficiencies. Under the weak form of market efficiency, the past trend of
stock price is publicly available. Investors readily incorporate any information that
can be deduced from the past trend to the current stock price. However, the market is
not efficient enough to incorporate any fundamental analysis or inside information,
and thus provide opportunities for abnormal profits. Under semi-strong form of
market efficiency, information of fundamentals including the filings of companies are
publicly available in addition to the stock price trend. Thus, only the inside
information will enrich investors. Under strong form of market efficiency, nobody can
achieve persistent positive risk-adjusted return above the benchmark even with inside
information.
To examine abnormal profit under EMH in the real market, empirical
evidences regarding the violations with respective exploitability are needed to assess
the possibility in generating the positive risk-adjusted return above the benchmark.
The study of abnormal return with EMH involves studying the flow of information
into market prices and related anomalies (Ball, 2009).
Ball from the University of Chicago notes that testing of EMH is somewhat
limited. The information that investors pricing in is subjected to changes. Variables
such as Federal Reserve policy, tax rates, investor demographics, technological
change, and labor productivity affect asset pricing model but are not known
definitively (Ball, 2009). Researchers cannot gauge how variables evolve and
implications of such evolutions. In addition, the benchmark or aggregate security
price under efficiency is not conclusive. For example, during financial crisis,
sequence and constitutions of an efficient price reaction cannot be measured. For
individual stocks, it is even harder to analyze the existence and impact of variables.
The risk associated with the efficient price of a stock varies with occasional
uncertainties involving firms quality, and researchers [design] estimate and control
for the realized [with] the implicit assumption that the observed level is the correct
level (Ball, 2009).
Though the agreement on how rational the market is varies due to such
limitations on the study of the market, it generally converges to the idea that it is
efficient enough to prevent abnormal profits. To test if the market is rational,
researchers focus on examining anomalies possible failure of investors rationality.
If sometimes anomalies irrational behaviors reflected in the market occur and
predictable, investors may exploit them for abnormal profit. Unfortunately, however,
the conclusions of many researchers including Malkiel and Fama indicate that
anomalies carry statistical significance and predictable patterns but are not necessarily
exploitable (Malkiel, 2013).
Examples of well-known anomalies are the January effect, the size effect,
and, of course, stock market crises. Malkiel indicates that researchers found a
statistically significant high return in January; Returns from an equally weighted

stock index have tended to 11 be unusually high during the first two weeks of the
year (Malkiel, 2013). However, as the January effect was discovered along with
other calendar based anomalies such as the number of day-of-the-week effect, turn of
the month, and holidays effect, it has been gone. Logically, investors with the
knowledge of such effects would react and readily price in the information to the
current market; thus there will be no ongoing opportunities for exploitability and the
market becomes efficient through arbitraging (Malkiel, 2013).
The size effect suggests that even though some anomalies carry statistical
significance, they cannot be interpreted as market inefficiencies. The size effect refers
to the tendency that firms of small capitalization perform better than firms of large
capitalization in the long term. Since riskier stocks would likely to yield more than
safer ones, investors use the term beta the correlation of stocks return with the
market return - as the measure of systematic risk. Under the capital asset pricing
model which is profoundly used when valuing stocks and assumes beta as the
measure of systematic risk, the market was inefficient; stocks of small capitalization
yielded higher risk-adjusted return than stocks of large capitalization. However,
considering the insignificant relationship between beta and return during 1963-1990,
Fama suggests that the proper measure of systematic risk might have been the size of
firms instead of beta, and thus the size effect is not an anomaly (Fama, 1993).
Indeed, there exist seemingly irrational behaviors in the market and the most
controversial one is a bubble in the stock market. The anomaly known as the internet
bubble during the late 1990s assigned irrationally high valuations to internet and IT
related companies. Malkiel stresses that even though all participants in the market
value stocks rationally the present value of future cash flows it is still possible to
build a bubble. According to Malkiel, researchers now can point out the unsupportable
growth projection of internet and the exuberance of high valuations of IT companies
during the internet bubble, mainly due to the hindsight bias. During the bubble, most
of security analysts in the Wall Street had convictions in the internet sector and
institutional and individual investors valued those convictions. Thus, since the
valuation of stocks includes uncertain future forecasts [,] there were certainly no
arbitrage opportunities available to rational investors before the bubble popped [;]
nothing is ever as clear in prospect as it is in retrospect (Malkiel, 2013). It was hard
to pin down the true fundamental value, if it is ever possible, in the heated market,
and no one dared to arbitrage and sold short the stock with the expectation of decrease
in the stock price to its fundamental value (Malkiel, 2013).
In general, anomalies are more apparent in paper. The patterns of anomalies
might be false positive and are discontinuous. Due to the nature of non-experimental
science, economics researches rely on statistical analysis for their insights and cannot
test hypotheses by running repeated controlled experiments (Malkiel, 2013). If given
enough time, it is possible to find statistically significant but meaningless patterns.
Yet, it is impossible to prove the hypothesis with controlled experiment (Malkiel,
2013). Further, the replication of well-known anomalies proved that the anomalies in
a sample period, for example the size effect, do not exist in the different time periods.
The anomalies disappeared as the papers with their discussions were published
(Schwert, 2003). Real market strategies employing such published anomalies had
failed as well. Richard Rolls investment aiming to systematically exploit supposed
market inefficiencies had yet made him a nickel (Roll, 1992). In the end, regardless
of what strategies investors take, the efficient market destroys supposedly exploitable
anomalies and will only leave active investors the cost of transactions and of extra
futile risks; a 100 dollar bill on the ground will not last long.

Explaining the Irrationality: Adaptive Market Hypothesis

Andrew Lo explains the apparent irrational expectations and behaviors of
rational market through an evolutionary approach. He asserts that the market
participants, humans, have a complex decision making process. [Logical] reasoning
is only one among several" factors that contributes to the process; thus, ever changing
market efficiency and level of rationality are unavoidable due to the complexity in
participants decision making process (Lo, 2012). This rather newly developing theory
provides us explanations of irrational behaviors in the market and shortcomings of
EMH through an evolutionary approach.
The current market, according to Lo, is significantly different from the last
decade due to unprecedented innovations. Lo then asserts that under the environment
changes, [] it should come as no surprise that the heuristics of the old environment
are not necessarily suited to the new (Lo, 2004). The change in environment is
particularly evident in terms of short term volatility in the market. Of course, one
might think that the volatility was at its peak during the Great Depression, but the
highest volatility occurred during the subprime mortgage crisis in 2008. In addition to
volatility, other measures of market statistics such as trading volume, market
capitalization, trade-execution times, and the sheer number of listed securities and
investors suggest that the current market differs significantly from the previous ones.
The current stock market is unusually large, diverse and fast-paced compared to the
previous decades; the market is constantly changing (Lo, 2012).
First, the technological innovations spurred the growth of human population
which affectedly changed the market landscape and undermined a simple assumption
in individuals rational behaviors in the complex interactions. The growth of
population can be divided into 3 stages: low growth from the Stone Age, moderate
growth from the Bronze Age, and exponential growth from the industrial revolution.
The growth of world population was moderate at best until the industrial revolution.
However, the industrial revolution brought the exponential growth of world
population; it quadrupled the human population during the last century. With such
growth of population, the number of market participants exponentially increased since
individuals now must work and engage in investment activities and savings in order to
survive. The surge in the number of market participants inevitably increased the
required scale of financial markets as well as the complexity of the interactions
among the various counterparties (Lo, 2012).
Further, technological innovations that caused the dramatic increase in world
population shifted the global economy to instability; the economy now reacts more
quickly to innovations and information a new order. The advance in technology
contributed to the production of superfluous resources exceeding our needs. It helped
humans to reproduce more successfully, but the constant innovations in agricultural,
manufacturing and even financial sector brought competitiveness and ever-changing
market environment. In rapid development of technology, new innovations soon
become outdated and the market becomes more competitive and ever changing (Lo,
2012).
The world has become more connected through technology, and innovations
dramatically differentiated the current world from the past. The United States, for
example, had incomparably high GDP per capita and average life expectancy in 1939;
only few competitors existed. However, today, merely after 60 years, many
competitors emerged including Japan, and Europe. Moreover, the interaction between
developed and developing countries increased as emerging markets impact on global

trade patterns, labor supply, relative wages and production costs, foreign exchange
rates, and innovation and productivity (Lo, 2012). Complexity due to broader
interactions of nations thus exposed the supply and demand of real assets to greater
volatility in response to the greater scale; it brought a new order - unprecedented
dynamics of global financial asset prices (Lo, 2012).
Financial innovation further introduced dynamic instability by connecting
global capital markets. Though it facilitated tremendous global economic growth
over the past decade by gathering and channeling vast amounts of capital from asset
owners from one part of the world to entrepreneurs in other parts of the world, the
financial innovation exposed markets to the greater risks. It is evident in the recent
financial crisis that the failure of one market will quickly start an epidemic of worries
in other markets (Lo, 2012).
In this setting of new market environment, AMH takes an evolutionary
approach to interpret decisions and behaviors of participants. AMH recognizes human
behavior as a reflection of an individuals complex combination of decision making
systems which includes but is not limited to the logical reasoning (Lo, 2012). The
complex combination enables humans to comprehend abstract ideas and coordinate
behaviors to achieve complex goals. The abstract thinking and complex decision
making process involve the particular area called Neocortex in a mammals brain (Lo,
2012). The complex combination also includes our primitive survival mechanism
fight-or-flight response. Fight-or-flight response is a decision making process
intended to defend ourselves quickly by fighting or avoiding the threat instinctively
without careful consideration. It is a hardwired automatic response that humans
utilize to instinctively decide how to react upon imminent threats (Lo, 2012). In
AMH, complex combination of logical reasoning and fight-or-flight mechanism
along with decision making systems constitutes a behavior of participants or species
in the market (Lo, 2004)
With this evolutionary aspect, AMH, according to Lo, does not overthrow the
principles of EMH but rather augments them with evolutionary aspects. Under AMH,
the market consists of its environmental conditions and species, and the equilibrium
price is determined by the interactions of environmental conditions and species in the
ecology. Species do not refer to the general participants but rather specify distinct
groups which behave in a common manner (Lo, 2004). For example, hedge fund
managers behave differently from pension fund managers or individual retail
investors (Lo, 2004).
In AMH, the efficiency of market reflects how many species are competing
for the resource in the market. Thus, the market efficiency depends on the resources
that ecology provides and the number of inhabitants or participants in that ecology. If
multiple species compete for limited resources in a market, for example the market of
10-year US Treasury Notes, that market will be very efficient. On the contrary, if few
species participates in a market with abundant resources, that market will be not
efficient as the market of 10-year US Treasury Notes. Thus the market efficiency is
not fixed as in EMH but varies with existing species adapting to environmental
changes (Lo, 2004).
The adaptation of species to environmental changes also indicates that
specific investment strategies and species will experience the cycles of profitability
and loss depending on the condition of ecology. The cycle is due to behavioral biases
of species with different levels of heuristics in the ecology. For example, during the
internet bubble, species looking for liquid and safe investments dominated species,
mainly hedge funds, which employed the fixed-income relative-value strategy

attempted to arbitrage. Hedge funds with that strategy obtained considerable profits
before the bubble but miserably failed during and after the bubble; the species was not
fitted for the environment and the fittest survived (Lo, 2004).
Applications of AMH in Market: Source of its Critics
Lo acknowledges that AMH is still a developing theory and requires more
research to be operationally meaningful; AMH is an augmentation of EMH and
relies on the theory of EMH (Lo, 2004, Ball, 2009). However, he also claims that
even at its early stage of development, AMH reconciles apparent irrational behaviors
with the efficient market (Lo, 2004). The reconciliation derives 4 possible
implications with evolutionary principles, but often its inability to present positive
applications and its anomalies weakens its strength as a theory (Lo, 2004, Ball, 2009).
A first implication addresses the relationship between risk and reward. To
some extent, there exists a relationship between risk and reward and it is determined
by species and environments, such as tax laws, of the ecology. However, there is no
definitive measure of the relationship since species and environments changes over
time. Lo indicates that the risk premium is time-varying and path-dependent and the
risk preference of the market is subjected to changes made by natural selection (Lo,
2004). Investors with substantial losses during the internet bubble, for example, have
probably exited the market. Thus, the market is left with new species and their risk
preferences; however, the concrete evaluation of decision making process for
preferences is yet to be fully explored (Lo, 2004).
A second implication of AMH suggests that exploitable arbitrage
opportunities exist in contrary to EMH. Of course, in the efficient market with many
species, exploitable arbitrage opportunities quickly disappear. However, new
opportunities arise from the change in population of species and in environments. The
constant change in ecology brings more flexible dynamics with cycles of returns
which are the motivation for active management (Lo, 2004).
A third implication is that the performance of strategy in the same ecology
will vary at times due to different environments and species. Under EMH, the
profitability of investment strategies fades away as other investors acknowledge and
exploit it. However, under AMH, the constantly changing species and environments
alter the profitability of investment strategies. At times of financial crisis, a defensive
strategy will outperform a growth investing strategy, but as soon as the market
condition shifts as economy picks up, a growth investing strategy will beat the
defensive one. AMH implies that investors should not assume a stationary world in
which markets are perpetually in equilibrium (Lo, 2004).
A fourth and the last implication stresses the importance of survival. Under
EMH, investors can generate returns by taking relative risks associated with the level
of the expected return. AMH suggests different

A fourth implication is that innovation is the key to survival. The classical EMH suggests that
certain levels of expected returns can be achieved simply by bearing a sufficient degree of
risk. The 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.
By evolving a multiplicity of capabilities that are suited to a variety of 23 environmental
conditions, investment managers are less likely to become extinct as a result of rapid changes
in business conditions. Consider the current theory of the demise of the dinosaurs (Alvarez,
1997), and ask where the next financial asteroid might come from.
Finally, the AMH has a clear implication for all financial market participants: survival is the only
objective that matters. While profit maximization, utility maximization, and general equilibrium

8
are certainly relevant aspects of market ecology, the organizing principle in determining the
evolution of markets and financial technology is simply survival.

Weakness of AMH = not refutable and testable No anomalies since no reference

Implications
Weakness of AMH from Ball
Ball
Critics of AMH and behavioral finance in general discusses

Ray Ball from the University of Chicago notes that the lack of anomalies might not be
a good sign for a theory (Ball, 2009).
[To] discover anomalies one first must have a theory that is capable
of being contradicted. One of the strengths of the EMH is its
refutability: it can be tested. One gets the impression that behavioral
finance, taken as a whole, consists of a set of disjointed and
inconsistent ideas, some of which are rationalizations of the anomalies
of others. If all theories are abstractions and all theories have
anomalies, but behavioral finance has no anomalies, the implication is
that it is not a theory.
Conclusion: Suggestions for Future Active Management
shines new light on the active management as it provides alternative perspective on
the assessment of active management.
The reason of fleeing to passive management can be attributed to 2. 1. Past
unjustifiable performance with higher cost, 2nd the expectation that EMH will be
dominant.
The structure of asset management industry, specifically equity = it is more
about maintaining contracted investing philosophy.
Personal Career
I will find joy not in picking up but in searching for a 100 dollar bill. And there will
be plenty for me.
Reiteration

Wrap up paragraph
A fourth implication is that innovation is the key to survival. The classical EMH suggests that
certain levels of expected returns can be achieved simply by bearing a sufficient degree of
risk. The 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.
By evolving a multiplicity of capabilities that are suited to a variety of 23 environmental
conditions, investment managers are less likely to become extinct as a result of rapid changes
in business conditions. Consider the current theory of the demise of the dinosaurs (Alvarez,
1997), and ask where the next financial asteroid might come from.

Ang

9
Much of the tests of the EMH on managers focus on retail mutual funds. It does appear that
within the retail sector there is some evidence of differential skill. A Bayesian analysis of skill
in the mutual fund sector argues that passive indexing is difficult to justify when there is a
large population of managers. On the other hand, there is no compelling evidence that active
professional management in the retail sector has added incremental return to investors net of
fees.

Makiel
For me, the most direct and most convincing tests of market efficiency are direct tests of the
ability of professional fund managers to outperform the market as a whole. Surely, if market
prices were determined by irrational investors and systematically deviated from rational
estimates of the present value of corporations, and if it was easy to spot predictable patterns
in security returns or anomalous security prices, then professional fund managers should be
able to beat the market. Direct tests of the actual performance of professionals, who often are
compensated with strong incentives to outperform the market, should represent the most
compelling evidence of market efficiency. A remarkably large body of evidence suggesting that
professional investment managers are not able to outperform index funds that simply buy and
hold the broad stock market portfolio. The first study of mutual fund performance was
undertaken by Jensen (1969). He found that active mutual fund managers were unable to add
value and, in fact, tended to underperform the market by approximately the amount of their
added 31 expenses. I repeated Jensens study with data from a subsequent period and
confirmed the earlier results (Malkiel, 1995). Moreover, I found that the degree of
survivorship bias in the data was substantial; that is, poorly performing funds tend to be
merged into other funds in the mutual funds family complex thus burying the records of many
of the underperformers. Exhibit 4 updates the study I performed through mid-2002.
Survivorship bias makes the interpretation of long-run mutual fund data sets very difficult. But
even using data sets with some degree of survivorship bias, one cannot sustain the argument
that professional investors can beat the market. Exhibit 5 presents the percentage of actively
managed mutual funds that have been outperformed by the Standard & Poors 500 and the
Wilshire stock indexes. Throughout the past decade about three-quarters of actively managed
funds have failed to beat the index. Similar results obtain for earlier decades. Exhibit 6 shows
that the median large capitalization professionally managed equity fund has underperformed
the S&P 500 index by almost two percentage points over the past 10, 15, and 20-year
periods. Exhibit 7 shows similar results in different markets and against different benchmarks.
Managed funds are regularly outperformed by broad index funds, with equivalent risk.
Moreover, those funds that produce excess returns in one period are not likely to do so in the
next. There is no dependable persistence in performance. During the 1970s, the top 20
mutual funds enjoyed almost double the performance of the index. During the 1980s, those
same funds underperformed the index. The best performing funds of the 1980s similarly
underperformed during the 1990s. And a more dramatic example of the lack of persistence in
performance is shown in Exhibit 8. The top 20 mutual funds during 32 1998 and 1999
enjoyed three times the performance of the index. During 2000 and 2001 they did three times
worse than the index. Over the long run, the results are even more devastating to active
managers. One can count on the fingers of one hand the number of professional portfolio
managers who have managed to beat the market by any significant amount. Exhibit 9 shows
the distribution of returns over a 30-year period. Of the original 355 funds, only five of them
outperformed the market by two percentage points per year or more. The record of

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professionals does not suggest that sufficient predictability exists in the stock market or that
there are recognizable and exploitable irrationalities sufficient to produce excess returns.

11

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Lo The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective 2004

The Global Financial Crisis and the EMH: What Have We Learned?
by Ray Ball, University of Chicago*