Key Messages
How to Understand the Stock Market: An Exploration of Old and New Ideas
Adaptive Market’s book will give you a better understanding of financial markets and how they need to be fixed.
You’ll learn about the ideas that currently prevail in the stock market and also, the new ideas that the author has put forward as to how things can be improved.
This is an important topic, especially in light of recent events like the 2008 financial crisis, which highlighted just how much businesses—and all of us—rely on financial stability.
In these sections, you’ll gain insight into why this crisis occurred, what effects it had both near and far, and even find out why gambling addiction can help teach us about investment dangers.
With this knowledge, we can work together to come up with solutions for a better tomorrow.
It goes without saying that no one wants to go through something like 2008 again — but adaptive markets may show us a way forward.
Plus, there’s even potential for the market to be used to help solve medical problems such as cancer!
The Efficient Market Hypothesis: How Collective Wisdom Informs a Company’s Value
The Efficient Market Hypothesis (EMH) is the most widely accepted theory among leading experts in the investment sector for how the markets work.
It suggests that stock prices, bonds and similar investment assets will always provide an accurate reflection of a company’s health, profitability and value.
To see it in action, let’s look at what happened to Morton Thiokol after their faulty rocket part caused the Challenger Space Shuttle explosion in 1986.
It makes perfect sense that the value of their shares plummeted shortly afterwards since they had just encountered a huge setback.
The EMH takes into account the collective wisdom from investors who are constantly analyzing the market and using their assessments to reflect a company’s value through buying and selling price activity.
The theory holds that by putting all these financial minds together, you’ll get an accurate representation of a company’s worth.
The Adaptive Market Hypothesis: An Evolutionary Perspective on How Human Nature and the Efficient Market Hypothesis Shape the Financial Markets
The Adaptive Market Hypothesis is a paradigm that takes into consideration the logical rules of the Efficient Market Hypothesis (EMH) as well as human nature, which traditional models cannot do.
This is because, even if a company’s stock by all accounts appears healthy, it can still be wildly misvalued due to irrational decisions made by those in control of the market.
By accounting for both logical and illogical rules within economic systems, the Adaptive Market Hypothesis is better able to explain situations such as why John Bogle’s Mutual Fund was so successful.
When he introduced a new feature known as market cap weighted indexes, this was in response to increased competition, needing less work and cost to maintain than what other mutual funds required.
So when we look at the evidence outlined by the Adaptive Market Hypothesis, it all fits together since these features become attractive investments when competition gets high.
Lastly, in order for us to gain insight into how markets are valued and shifted, we need to take into account seemingly undesriable traits from humans such as overconfidence or fear of losing money – these are also natural parts of evolution according to the Adaptive Market Hypothesis.
In understanding these elements alongside economic forces like competition and innovation, we’re able to have an accurate picture of why things happen in finance what they do.
The Hazard of Human Irrationality: How Inefficient Behavior Can Derail Markets and Impact Lives
Humans are notoriously unreliable when it comes to making financial decisions.
Daniel Kahneman and Amos Tversky, two psychologists that have conducted insightful research on how we deal with money, found that humans tend to be so worried about avoiding losses that they take much greater risks in order to avoid losses rather than making gains.
This phenomenon is known as loss aversion and it can have seriously adverse effects on individuals and the markets as a whole.
Take Jérôme Kerviel’s case: He was a junior trader at Société Générale who attempted to cover his relatively small losses with one big risky move after another and ended up losing €4.9 billion in the process!
We also often fool ourselves by thinking we can predict what will happen next when dealing with money – something we call probability matching.
We may think betting on a red number for every round at roulette should give us better odds of winning but if the numbers keep repeating themselves our success rate would actually drop from 75 percent to only 62.5 percent.
It’s irrational, yet expected behavior from us humans when dealing with money – even if we know it’s wrong.
Our Tendency to Make Irrational Decisions with Money and Why It Happens
Humans are prone to making extremely reckless and irrational decisions when it comes to their finances, and this is largely due to our emotional reactions.
Neuroscience has revealed that decisions made in moments of high emotion are often driven by instinct rather than rational, conscious thought.
For example, activities like sex, gambling and cocaine all produce the same result in the brain: the release of dopamine which creates a feeling of reward and pleasure.
Research has concluded that dopamine plays a major role in causing people to act recklessly or take unreasonable risks.
This explains why slot machines use psychological manipulation tactics such as framing losses as wins – it keeps dopamine levels elevated in players so they will keep playing even if they are losing money.
Repeatedly exposing ourselves to these activities can lead us down a dangerous path – we become addicted and continue engaging despite the negative consequences.
That’s why situations such as airplane engine failure require professionals to proactively train themselves to override their instincts with calculated, rational responses; if pilots panic and instinctively pull up on controls during a crash landing, they will reduce speed and make it more difficult for the plane to coast safely on the ground.
The Adaptive Market Hypothesis: How Survival of the Richest Drives Evolution in Financial Markets
When it comes to financial markets, the law of the land is not “survival of the fittest,” but rather, “the survival of the richest.” This phenomenon can be seen in hedge funds, which are just one example of the Adaptive Market Hypothesis at work.
Hedge funds are partnerships between wealthy investors that were first pioneered in 1949 by Alfred Winslow Jones.
By buying favorable stocks and shorting weaker stocks, Jones was able to see returns of over 20% per year while also hedging against risk – hence the name hedge fund.
As news spread about his success, more and more hedge funds began appearing.
This illustrates how competition, innovation and adaptation between different economic species often rely on “survival of the richest” for success.
While some weak hedge funds may die out quickly, other more successful ones have grown exponentially, showing that those with superior traits will survive in today’s financial markets.
The Adaptive Market Hypothesis: Adapting to Changing Market Conditions for Long-Term Investment Success
The Adaptive Market Hypothesis can be used to make better financial decisions than the Efficient Markets Hypothesis which simply states that stock prices accurately reflect their intrinsic value.
The Adaptive Markets Hypothesis provides investors with an option to stay flexible and adjust to changes in the market.
This has shown to work in circumstances such as the Japanese market crash of 1991, when the prices remained stagnant for over 20 years.
The idea behind the Adaptive Market Hypothesis is that it’s sometimes best to adapt according to changing conditions of the market.
An example could be when a stock’s price drastically decreases due to irrational investors wanting to sell off at all costs resulting in what is known as a “behavioral premium” where buying or selling decisions are based on emotion rather than logic.
In these cases, it would be unwise to rely on an efficient market as this approach may not yield any profit or meet your goals.
By taking an adaptive approach and being willing to switch up your investments depending on financial conditions, you are increasing your chances of making a good decision and attaining long-term success.
The Adaptive Markets Hypothesis Explains Why Financial Institutions Struggle to Adapt and How It Led to the 2008 Financial Crisis
Financial crises can be seen as a result of markets evolving without proper oversight and evaluation.
The 2008 financial crisis is a perfect example of this.
When investors had to make tough decisions in the wake of the crisis, many cast blame and looked for an explanation.
The Adaptive Markets Hypothesis offers some insight into why the crash happened in the first place.
It states that when markets are changing too quickly for investors to adapt, it can create chaos and instability which eventually leads to a financial crisis.
This was exactly what happened in the 1990s, when adjustable-rate mortgages created new business opportunities like collateralized debt obligations and credit default swaps that were eagerly embraced by investors – something economists were largely oblivious to.
But with this theory, hindsight is 20/20; if proper oversight had been implemented earlier on, then perhaps the financial catastrophe could have been prevented or at least softened before it spread worldwide.
Instead, by the time people realized what was going on, it had become too late – banks investments had dropped significantly and share prices crashed.
The Adaptive Market Hypothesis Can Show Us a Better Way Forward: Using the Financial Industry for the Good of Humanity
The Adaptive Market Hypothesis (AMH) isn’t just about keeping our financial systems functioning well- it can offer possible solutions to many of the world’s biggest problems.
Take the example of biomedicine- there is very little private investment being made in this field due to its risky nature.
However, if we could put the same level of attention and investment that we pour into other sectors of the economy, such as finance, then perhaps we could make significant advances in curing diseases like cancer within our lifetime.
Hypothetically, a “CancerCures” fund could be established and managed by a panel of biomedical experts and experienced healthcare investors.
It would be funded using bonds similar to those used during World War II, with 150 independent research projects under its umbrella.
That way, risk could be spread across multiple projects while still achieving a high chance of success; with so many different missions at play, there is an estimated 98% probability that at least three would yield good returns!
Wrap Up
The Adaptive Markets Hypothesis outlined in the book provides a highly insightful approach to understanding our financial markets.
It offers an alternative to traditional models by incorporating the evolutionary element of market behavior that is largely due to human flaws and biases.
The final summary of this book is one of great optimism.
Rather than view the markets as a purely rational system, it emphasizes that there are human motivations and actions at play, and thus opens the door for great potential within the system to create positive change.
As such, this is an invaluable approach from which anyone involved in the markets should take away valuable lessons from.
