Adaptive Markets

Adaptive Markets gives you a better understanding of how the movement of money in the world works by outlining the characteristics of the market, some of which are more like living creatures than you might think.

You’re probably wondering how the markets work in the first place, right? One key element is the Efficient Market Hypothesis, which is the prevailing theory explaining the mechanisms of the market.

The main idea of this theory is that asset prices, like those of stocks or bonds, will always accurately tell the story of a company’s overall health, profitability, and value. It’s not perfect, but experts agree that the Efficient Market Hypothesis is the best.

To understand this, consider the example of Morton Thiokol, a company that helped NASA with the construction of rockets in the 80’s. When the Challenger Space Shuttle exploded in 1986, some of the company’s faulty equipment used in the construction of the shuttle was to blame.

Share values of the company dropped significantly in the wake of these tragic events. This isn’t a surprise due to the major setback the company now faced.

This hypothesis also accounts for the irrational emotional behavior of people. It does this with the idea that everything in the market evolves and happens for a reason. For example, when the market cap weighted indexes feature was introduced, it made investing cost less time and money. More investors began to using it. The tool transformed the landscape of investing and is in almost all mutual funds today.

Just like natural selection, competition and innovation make for an ever-changing and improving market.

You know about natural selection and the phrase “survival of the fittest” that describes it. This theory says that only species with the best traits for survival will continue on. These characteristics also begin to show up more often. The same is true for economies. Instead of species trying to survive, however, it’s investors, regulators, hedge funds, and companies that are competing to stay afloat. In these terms “survival of the fittest” becomes “survival of the richest.” In other words, only the optimal qualities lead to wealth, so those traits will begin to stand out in the evolution of the market. Let’s take a look at an example. Hedge funds began with Alfred Winslow Jones in the late 40s. Beginning with $100,000, Jones bought healthy stocks with growth potential and sold short those that weren’t performing as well. In this way he was hedging his bets, which is where the name hedge funds comes from. Jones’s method was wildly successful, and he saw returns over 20%. Although firms still operate with a lot of secrecy, we still see this same pattern today. This evolutionary…