The Discovering Markets Hypothesis (DMH)

The US financial economist Andrew W. Lo made an intriguing attempt to overcome the contradiction between the efficient markets hypothesis (EMH) and behavioral finance. He connected both by making them state dependent and dubbed his new theory the Adaptive Markets Hypothesis (AMH).

Lo reasoned that in times of continuous market developments, people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model. But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join the stampede, either rushing into the markets out of fear of missing out (FOMO) or fleeing from them from fear of going broke.

But why should normally “rationally” acting professional investors suddenly turn “irrational” in market downturns? And why should normally “irrationally” acting retail investors suddenly turn “rational” in normal markets? And why do environments change from “normal” and continuous to “abnormal” and discontinuous? In a new paper, my colleague Marius Kleinheyer and I propose another approach to explain price movements in financial markets.

We call it the Discovering Markets Hypothesis (DMH).

We begin with three central assumptions: That information does not exist as an object, that subjective receptions of complex inputs are communicated through narratives, and that shared narratives shape prices and are shaped by them.

Here are our key points:

1. Friedrich Hayek viewed information as subjective rather than objective knowledge. The knowledge in each of our heads is distinct from what’s in other heads because it reflects our specific and unique ability to collect and process information. When investors act or observe action in the market, they can improve their knowledge by comparing theirs to others. Practical knowledge is often implicit. Investors may not articulate it and it cannot be objectively measured.
2. Investors also communicate with each other to crosscheck their subjective knowledge. But complex knowledge is difficult to communicate. Robert J. Shiller has said that it is easier to communicate ideas when they are expressed in narrative form. As market participants share narratives and act on them, prices move. In turn, the movement of prices feeds back into the narratives.
3. Thomas Kuhn’s and Imre Lakatos’s insights into the creation of new scientific knowledge are valuable guides for understanding the effects of new knowledge and narratives on the market. Participants who act on a new shared narrative influence market prices. For some time, new and old narratives may compete. The emerging narrative may change or incorporate new ones during this competition. Sometimes the battle is intense and the victory absolute, as Kuhn described the revolutionary paradigm shift in science. At other times, the battle is drawn out and the new narrative displaces the old only gradually, as Lakatos theorized. Either way, the argument will be settled and a new narrative will rule.

Facts create subjective knowledge that may induce financial market participants to act. More likely, however, investors will exchange this knowledge with a view to identifying shared narratives, which have a more powerful influence on prices than individual action.

Although Lo’s AMH and our DMH start with the same insight — that markets may alternate between continuity and discontinuity — there are important differences:

First, AMH takes the change in states as given, while DMH explains the change in states as a function of how knowledge emerges and spreads in narrative form. Second, AMH assumes the disordered minds of investors and explains their varying behavior with psychology, while DMH assumes psychologically stable market participants whose behavior is consistent, continuous, and what we call subjectively rational. Thus, by focusing on the process of augmenting knowledge in a battle of narratives, DMH provides what we believe is a more useful framework for analyzing and predicting market behavior.

All this implies that we should not expect to be able to predict market outcomes. But by understanding how markets move, we can better focus on what is important for the result. Identifying and observing the drivers of market developments can help us narrow down the range of outcomes. Specifically, DMH suggests that we focus on how new facts influence narratives, which shape prices and are reshaped by them.

By identifying narratives shared among many people and by determining whether these narratives are ascending or descending, we can assess the persistence of market price movements. In some cases, we may even identify narratives that precede price movements.

For more on behavioral finance, don’t miss Popularity: A Bridge between Classical and Behavioral Finance from the CFA Institute Research Foundation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Nataniil

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