Andrew W. Lo: Adaptivemarkets: financial evolution at the speed of thought

Abstract

The efficient market hypothesis has been the prevailing theory in describing how financial markets work. It dates back roughly 50 years and states that market prices are a perfect reflection of all available information. The efficient market hypothesis is closely related to rational expectations of market participants and, therefore, the homo economicus. Eugene Fama describes an efficient market in his article “Random walks in stock market prices” in 1965 “as a market where there are large numbers of rational, profit-maximizers actively competing […]”. Over the course of years, the fact that market participants act as rational investors has been put into question by documenting “irrational” behavior of investors. Behavioral finance approaches this by assuming that investors are “human” and hence subject to biases and non-standard preferences possibly causing market inefficiencies.