Adaptive Market Hypothesis

Let me start off by saying that I am a proponent of this approach. It explains why I do not care much about having any particular style or approach to the market. It explains also why I embrace the full spectrum of approaches from scalping to long term income investing. It explains the extent of my open mindedness to the variety of valid approaches there is to the market (ie DCA) as well as to the extent I will not champion any strategy in particular. (Remember Wheelock)

Google and read up on the Adaptive Market Hypothesis by Andrew Lo. I shall not regurgitate what it is. More important are the implications. Which I will discuss.

  1. Forward statistics are not stable. (I cannot emphasise this enough)
  2. There are opportunities for arbitrage (Think market making, topic for another day)
  3. Investment strategies (A huge variety) will perform well in certain conditions and poorly in others.
  4. It is all about being profitable, utility maximisation not a priority.
  5. Innovation and adaptation to the changing market condition is key.

Point 1

There was a period in time where older folks made wagers on the local shares based on the overnight outcomes of the US DOW cash market close. There was a period of time where Asian markets climb when Japanese Yen weaken and vice versa. There are other examples of correlations once relied upon but have become less reliable.

In fact, every technical indicator and fundamental analysis ratio conceived, is proof that it once had explanatory power but have declined in efficacy. Mix and match them, optimise the variables every half yearly, back test to find good fit. All these actions are playing catch up at best. Being entirely rules based, is kinda dangerous. Implicitly it suggests that the market can be rationalised, when the truth is that the market contains both rational and irrational elements. The real joke is when I observe people rationalising instances of irrationality.

Point 2

Yea there is the law of one price, which states that no 2 identical items should be selling for different prices. But here’s the thing, markets are efficient, not always correct. But before going all ballistic on the difference between price and value, let me state that I am not all that hung up on the intrinsic value to be honest. I pay attention to changes instead. And besides, there is also the concept of willingness to pay. Trust me, there is such a thing as you are so much in-the-money but you cannot exit from the investment because no one wants to pay for your asking price, and the lowest bid acceptance involves giving up much of the returns.

Price can stay over priced and value can stay undervalued for an extended period of time. Always remember the phrase that the market can stay irrational LONGER than you can stay solvent ~ John Maynard Keynes. Do you still think market timing to be irrelevant and unimportant? There are opportunities to catch, but is your approach to the market in sync?

Point 3

In exaggeration, if you use technical considerations when the price moves are better explained with fundamentals, you are asking for trouble. The reverse is also true. And if you are using contrarian style on a trending market, you are doing yourself a disservice. Likewise, trending methods when the market is sideways consolidation, is asking for trouble.

If I were to put you in the hot seat, at the point in time where the price can breakout or reverse back into consolidation zone, can you see that there are 2 valid approaches? One will make money, and the other will lose. More importantly, are there risk management (cut loss) arrangements in place?

Point 4

I recognise that forecasting will forever be a craft. The best laid plans can be up-ended by a Trump tweet. Even if there is a target price, new information changing the market dynamics will mean not hitting that target within the expected time frame. If you are in the money, what is your response? Position management is equally important because I find many people are so focus on entry and exit targets, that one simple truth prevails; if the market don’t give, you cannot take.

The market is larger than anyone. Stay respectful of the market and be humble always. Yes a trend may have been caught, but how long it lasts is anybody’s guess and not cast in stone. To have a profitable position gone negative due to arrogance in the face of the market, is foolish.

Point 5

Put the cart (method/approach/strategy) behind the bull (market), not in front of it. I believe it is important to know what conditions will a particular method fail. There is a lot of innovation out there ranging from robo-advisors to smart beta just to name a few.

Apply the Portfolio Management Process. Make your own play. If you need assistance, do make an appointment with me.

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