CHAPTER 4

Adaptive Markets and Trend Following

Financial theorists and practitioners both agree that the classic efficient markets hypothesis (EMH) may often fall short of explaining certain aspects of dynamic trading strategies. The core issue with efficient market theory comes from the fact that it presents a somewhat static view of the behavior of markets. On the other hand, behavioral finance suggests that we systematically deviate from what most economists label rational expectations. In reality, markets are adaptive and market conditions continue to evolve over time as a function of the market environment and the composition and level of competition present in financial markets. The adaptive markets hypothesis (AMH) is a framework for explaining how markets behave using principles from evolutionary biology. In an adaptive markets framework, it is precisely the market players that are best able to adapt, which by the forces of natural selection are able to compete and survive to continue competing in highly competitive and dynamic financial markets.

In this chapter, as proposed by Andrew Lo (2004, 2005, 2006, 2012), the AMH is introduced to provide more detail into how to understand dynamic trading strategies. Using this framework, it is much easier to understand dynamic strategies, ...

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