What principle does the adaptive market hypothesis apply to financial markets?

The adaptive market hypothesis (AMH) proposes that financial markets are not always efficient, as suggested by traditional efficient market theory, but instead behave in ways that can be influenced by evolutionary principles. This hypothesis integrates elements from behavioral finance and evolutionary biology, suggesting that market participants adapt to changing environments and that market dynamics reflect these adaptations over time.

The concept of evolution in this context relates to how traders and investors learn and adapt their strategies based on their experiences and the outcomes of previous market events. This adaptability suggests that market efficiency is not a static condition but fluctuates as participants evolve their strategies in response to varying market conditions. As such, the AMH explains market behavior as a complex interplay between rational decision-making and the psychological factors that drive human behavior in response to shifting market environments.

This principle of evolution offers a more nuanced understanding of market functions, acknowledging that human behavior, emotions, and learning processes play crucial roles in shaping market dynamics, which is not captured by strict mathematical models that ignore human behavior.