Testing the empirical validity of the adaptive markets hypothesis
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The issue of market efficiency attracted the attention of academicians since the existence of financial markets. Over time, two schools of thoughts were established: the efficient markets school and the behavioral finance school. Proponents of the former believed in the Efficient Markets Hypothesis whereas the latter brought evidence from behavioral finance and psychology to demonstrate that financial markets are inefficient and this inefficiency is attributed to irrational behavior of investors in making financial choices regarding asset allocation and portfolio construction. Recently, an adaptive reconciliation was suggested, which posits that investors’ adaptability is what brings back inefficient markets to efficiency. The purpose of this paper is to test empirically the validity of the Adaptive Markets Hypothesis via a smooth transition regression model with market-to book ratio as exogenous threshold variable. The results support the reconciliation and show that markets are indeed efficient sometimes and inefficient most of the time. Keywords: Efficient Markets Hypothesis, Adaptive Markets Hypothesis, Smooth Transition Regression Models, Regime Switching Models, Irrationality, S&P500, Market to-Book Ratio
DescriptionThe Review of Economic Analysis requires that authors release their work under Creative Commons Attribution Non-Commercial license. This license allows anyone to copy, distribute and transmit the work provided the use is non-commercial and appropriate attribution is given. This article is available online at http://rofea.org/index.php?journal=journal&page=article&op=view&path%5B%5D=360&path%5B%5D=163.
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