Practical analysis for investment professionals
20 March 2019

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).

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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.

Formation of Prices

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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About the Author(s)
Thomas Mayer, CFA, PhD

Thomas Mayer, CFA, PhD, is founding director of the Flossbach von Storch Research Institute. Before this, he was chief economist of Deutsche Bank Group and head of DB Research. Mayer held positions at Goldman Sachs, Salomon Brothers, and before entering the private sector, at the International Monetary Fund (IMF) and the Kiel Institute. He received a doctorate in economics from Kiel University in 1982. Since 2003 and 2015, he is a CFA charterholder and honorary professor at University of Witten-Herdecke, respectively.

1 thought on “The Discovering Markets Hypothesis (DMH)”

  1. Norbert says:

    I think this article rather refines the discontinuous approach of AMH from Lo than replacing parts of it. The switching between rational and irrational behavior of market participants may be unexplained by AMH. But it is consistent with switching between slow, rational, unbiased on the one hand and fast, irrational, biased thinking and subsequent behavior on the other, which Kahnemann discovered.

    Thus, the answers to the author’s questions, intended to motivate his continuous approach, are rather obvious. The author asks:
    “But why should normally “rationally” acting professional investors suddenly turn “irrational” in market downturns?”
    Well, because their main drivers are peer pressure, career risk and opportunity, which may cause them to switch to fast irrational behavior when market dynamics rises due to innate fear and greed, respectively, just as behavioural economics explains it.

    “And why should normally “irrationally” acting retail investors suddenly turn “rational” in normal markets?”
    Because large losses may sober them or bankruptcy just ends their game.

    However, why should professional and retail investors usually act in these opposite ways predominantly rationally and irrationally, respectively, in the first place?

    After watching the authentic German TV series “Bad Banks” and learning of the god-like attitudes as well as of the dysfunctionally selfish behaviour of large public banksters, such as Blankfein from Goldman Sachs, doing “God’s Work”, and the like, playing irresponsibly with other people’s and taxpayer’s money, on the one hand, and knowing my own way and that of friends of much longer-term buy-and-hold investing mainly for retirement with consequently contrarian rebalancing, I would rather assume that professional and retail investors rather act opposite, namely predominantly irrationally and rationally, respectively.

    This would also be much more consistent with the fast and thus more irrational behaviour in the fast business environment and with the slow and thus more rational behavior in the slow private environment.

    Thus, markets are dominated by large irrational market players. As there are certainly large rational professional participants as well, such as excellent pension, endowment (Yale) and hedge funds (Bridgewater, Winton), rationality and irrationality should be more normally distributed in the professional and retail world.

    “And why do environments change from “normal” and continuous to “abnormal” and discontinuous?”
    These are rather simple non-linear effects of complex systems with self-amplifying positive feedback loops due to reflexivity, escalating until they hit hard boundaries and break down.

    However, the approach of the author with “subjective” rationality may indeed help to explain the behaviour of practically always subjectively rational market participants with incomplete information and understanding, be they professional or retail investors, and the respective effects on longer-term continuous dispersion of returns patterns of many years and even decades before mean reverting a little better.

    But in my opinion it does not change any assumptions or implications of the AMH. Because it’s discontinuities can be well explained by the outright irrational behavior, guided by incompetence and strong emotions of the majority of professional and retail investors alike. Relatively frequent discontinuous changes into phases of irrational exuberance and following disruptions are well known effects of 2nd order chaotic systems such as the financial system.

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