A note on the relationship between market efficiency and adaptability – New evidence from artificial stock markets

• Greater genetic diversity characterised by Hurst exponent of 0.5.
• The presence of more traders is related to a short-memory process.
• The standard deviation is higher in markets with fewer traders.
• There is no presence of ARCH effect in the most efficient markets.
• Market adaptability in line with the null hypothesis of BDS and Kaplan tests.

We developed various artificial stock markets populated with different numbers of traders using a special adaptive form of the Strongly Typed Genetic Programming (STGP)-based learning algorithm. We then applied the STGP technique to historical data from three indices – the FTSE 100, S&P 500, and Russell 3000 – to investigate the formation of stock market dynamics and market efficiency. We used several econometric techniques to investigate the emergent properties of the stock markets. We have found that the introduction of increased heterogeneity and greater genetic diversity leads to higher market efficiency in terms of the Efficient Market Hypothesis (EMH), demonstrating that market efficiency does not necessarily correlate with rationality assumptions. We have also found that stock market dynamics and nonlinearity are better explained by the evolutionary process associated with the Adaptive Market Hypothesis (AMH), because different trader populations behave as an efficient adaptive system evolving over time. Hence, market efficiency exists simultaneously with the need for adaptive flexibility. Our empirical results, generated by a reduced number of boundedly rational traders in six of the stock markets, for each of the three financial instruments do not support the allocational efficiency of markets, indicating the possible need for governmental or regulatory intervention in stock markets in some circumstances.