1. as the Adaptive Market Hypothesis (AMH),
1.IntroductionInrecent years the effectiveness of the Efficient Market Hypothesis (EMH) hasbeen substantially questioned by the financial economists and a new theory relatedto the market behaviour, known as the Adaptive Market Hypothesis (AMH), wasproposed. In order to critically assess and contrast these theories it is necessarynot only to define them, but also to discuss their respective strengths andweaknesses. TheEMH is a financial theory asserting that market prices fully and rationallyreflect all available information at all times, immediately adjusting to changesin available information.
The market stock prices in this hypothesis are assumedto follow a ‘random walk’, meaning that are no patterns or trends to returns.Thus, the current stock prices do not provide any information about the stockprices in the future and hence are unpredictable. As a result, any arbitrage opportunitiesare eliminated, preventing an investor from achieving high returns without facinga high risk. However, the increasing importance of behavioural economics haschallenged the EMH, claiming that investors often behave irrationally. Principlesof evolution such as competition and natural selection often significantly effectinvestors’ choices. To account for this fact, an alternative theory may beneeded to explain the market behaviour. The hypothesis proposing the intersectionof psychology and economics is known as the AMH. The raised questions arewhether the EMH indeed is inefficient in explaining the investors’ behaviour andwhether the AMH offers a more accurate clarification of the determination ofthe market prices.
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2. Efficient Market HypothesisTheroots of the EMH go back to the 1970s when Paul Samuelson proved that the stockmarket prices follow a random path and consequently, Eugene Fama argued that amarket is efficient if “prices always fully reflect all available information” (Fama(1969), p.383). This implies that for markets to be efficient a change inavailable information will immediately change the stock prices and no under-pricedor over-priced stocks can be found on the market. Hence, an investor cannotearn abnormal profit by using information relevant to the stock.
The concept ofthe EMH is that if there were any arbitrage opportunities available, they wouldalready been taken as there are constantly investors