Adaptive Markets Hypothesis - A more compelling story?

How rational are investors actually?
From Yale Economic Review..

According to the theory, the market is a dynamic ecosystem, and investors make decisions based on past experience instead of solely optimizing utility. In this framework, behavioral biases are abundant but explainable. In trying to adapt, investors replicate past successes or abandon failed strategies. But they commit apparently irrational mistakes by trying to apply old strategies to new market situations. Natural selection can also change aggregate behavior by forcing unsuccessful investors out of the market.

In the market ecology, the value of scarce resources – prices – are determined by the interaction between environmental conditions and the number of investor “species” in the market. All else being equal, the more species present, the greater the level of competition, which leaves fewer opportunities to profit and makes the market more efficient. A lack of competitors causes slower incorporation of information into prices, yielding more and longer lasting profit opportunities. In the AMH framework, the EMH is the steady-state solution of a market with an unchanging environment, whereas the findings of behavioral finance reflect dynamic adaptations which may succeed or fail.

The AMH leads to fascinating implications for financial theory. Unlike in the EMH, “history matters,” Lo asserts. Risk preferences in the AMH, for example, change according to past market prices. Current investors’ average risk preference, for example, has decreased because risk-loving investors who suffered losses in the tech stock bubble of the late 1990s left the market after its fall in 2000 and 2001.

There are also important practical applications of the AMH. In contrast to the EMH, the AMH implies that portfolio research is not completely useless, because markets can be biased by past prices. To survive market changes, innovation is also essential for survival, so investment managers must develop diverse methods suited to different environmental conditions. Knowing that behavioral biases are inevitable, good financial advisors should seek to point out harmful biases to their clients.