Although few of us encounter such threats on a daily basis, much of
our instincts are still adapted to the plains of the African savannah
50,000 years ago. Brain scans have shown these same instincts can be
triggered by more modern threats such as shame, social rejection and
financial loss. And as social animals, humans will react en masse if
the perceived threat is significant enough, occasionally culminating
in lynch mobs, riots, bank runs and market crashes. Markets are not
always efficient, nor are they always irrational - they are adaptive.
This Adaptive Markets Hypothesis - essentially an evolutionary
biologist's view of market dynamics - is at odds with economic
orthodoxy, which has been heavily influenced by mathematics and
physics. This orthodoxy has emerged for good reason: economists have
made genuine scientific breakthroughs, such as general equilibrium
theory, game theory, portfolio optimisation and derivatives pricing
models. But any virtue can become a vice when carried to an extreme.
The formality of mathematics and physics, in which mainstream econ-
omics is routinely dressed, can give outsiders - especially business
leaders, regulators, and policymakers - a false sense of precision
regarding our models' outputs.
From an evolutionary perspective, markets are simply one more set of
tools that Homo Sapiens has developed in his ongoing struggle for
survival. Occasionally, even the most reliable tools can break or be misapplied.
The AMH offers an internally consistent framework in which the EMH
and behavioural biases can coexist. Behaviour that may seem irrational
is, instead, behaviour that has not yet had time to adapt to modern
contexts. For example, the great white shark moves through water with
fearsome grace, thanks to 400m years of natural selection. But place
it on a beach, and its flailing will look . . . irrational.
The origins of human behaviour are similar, differing only in the
length of time we have had to adapt to our environment (about 2m
years), and the speed with which that environment is now changing.
Like the six blind monks who encountered an elephant for the first
time - each monk grasping a different part of the beast, and coming to
a wholly different conclusion as to what an elephant is - disciples of
the EMH and behavioural finance have captured different features of
the same adaptive system.
The implications of the AMH for regulatory reform are significant.
Markets can be trusted to function properly in normal times, but if
humans are subject to emotional extremes, animal spirits may overwhelm
rationality, even among regulators and policymakers.
Therefore, fixed rules that ignore changing environments will almost
always have unint- ended consequences: those enacted in the aftermath
of crisis may be too severe during normal times, and those repealed
after long periods of prosperity may lead to future excesses. The only
way to break this vicious cycle is to recognise its origin - adaptive
behaviour - and design equally adaptive regulations to counterbalance
The writer is Harris & Harris Group Professor at the MIT Sloan
School of Management