During the last decade, two deep bear markets, as results of tech bubble and mortgage crisis, have challenged the conventional wisdoms such as modern portfolio theory (MPT) and Efficient Market Hypothesis (EMH). Those assumptions include:
- There is a linear positive risk/return tradeoff across all financial assets;
- The risk/return relationship is static across time;
- The parameters such as expected return, expected standard deviation and correlations, CAPM betas can be accurately estimated;
- The return distributions are stationary, static and can be accurately estimated;
- Market participants are rational;
- Markets are efficient.
Although these assumptions may be good approximation for the long run, most of them are hardly the case within reasonable investment horizon of any investors, e.g. 5 – 20 years. In a shorter horizon, all the parameters are highly unstable. These assumptions seem inadequate in explaining market behaviors.
As an alternative, the Adaptive Markets Hypothesis (AMH), proposed by MIT Professor Andrew Lo, in which intelligent but fallible investors constantly adapt to changing market conditions, helps explain the importance of macro factors and market sentiment in driving asset returns. The adaptive investment approach, under which investors can adjust their investments to reflect economic regimes, ongoing market return or market volatility. Some of the investment strategies such as regime-based investing, momentum strategy, trend following or risk parity fall into the framework. This approach has the potential to deliver consistent returns in any market environment, by dynamically positioning in the financial assets perceived to have best return potential under the ongoing market and economic condition. For example, in the risk-seeking (“risk on”) environment, the strategy allocates to risky assets such as equities, commodities, real estates or high yield bonds; in the risk-avoidance (“risk off”) environment, the strategy invests in safe assets such as Treasuries or cash. Instead of forecasting future returns under the traditional active investment framework, the adaptive approach focuses more on identifying the market regimes and conditions and adjusting the investment strategies accordingly.
For more information about the Adaptive Investment Approach, please read our thought piece.