One thing I would add is that the EMH also suggests one can make deviations that don’t have very high EMH-predicted costs. Small investors do underperform indexes a lot by paying extra fees, churning with losses to spreads and capital gains taxes, spending time out of the market, and taking too much or too little over risk (and especially too much uncompensated risk from under diversification). But given the EMH they also can’t actively pick equities with large expected underperformance. Otherwise, a hedge fund could make huge profits by just doing the opposite (they compete the mispricing down to a level where they earn normal profits). Reversed stupidity is not intelligence. [Edited paragraph to be clear that typical retail investors do severely underperform, just mainly for reasons other than uncanny ability to find overpriced securities and buy them).]
That consideration makes it more attractive, if one is uncertain about an edge, to consider investments that the EMH would predict should be have very modest underperformance, but some unusual information would suggest would outperform a lot. I was persuaded to deviate from indexing after seeing high returns across several ‘would-have-invested in’ (or did invest a little in, registered predictions on, etc) cases of the sort Wei Dai discusses. So far doing so has been kind to my IRR vs benchmarks, but because I’ve only seen results across a handful of deviations (one was coronavirus-inspired market puts, inspired in part by Wei Dai and held until late March based on a prior plan of letting clear community transmission in the US become visible), and my understanding from colleagues in the pandemic space), the likelihood ratio is weak between the bottom two quadrants of your figure. I might fill in ‘deluded lucky fool’ in your poll. Yet I don’t demand a very high credence in the good quadrant to outweigh the underdiversification costs of using these deviations as a stock-picking random number generator. That said, the bar for even that much credence in a purported edge is still very demanding.
I’d also flag that going all-in on EMH and modern financial theory still leads to fairly unusual investing behavior for a retail investor, moreso than I had thought before delving into it. E.g. taking human capital into account in portfolio design, or really understanding the utility functions and beliefs required to justify standard asset allocation advice (vs something like maximizing expected growth rate/log utility of income/Kelly criterion, without a 0 leverage constraint), or just figuring out all the tax optimization (and investment choice interactions with tax law), like the Mega Backdoor Roth, donating appreciated stock, tax loss harvesting, or personal defined benefit pension plans. So there’s a lot more to doing EMH investing right than just buying a Vanguard target date fund, and I would want to encourage people to do that work regardless.
I’d also flag that going all-in on EMH and modern financial theory still leads to fairly unusual investing behavior for a retail investor, moreso than I had thought before delving into it.
Seconding this. It turns out that investing under the current academic version of EMH (with time-varying risk premia and multifactor models) is a lot more complicated than putting one’s money into an index fund. I’m still learning, but one thing even Carl didn’t mention is that modern EMH is compatible with (even demands) certain forms of market timing, if your financial situation (mainly risk exposure through your non-investment income) differs from the average investor. This paper gives advice based on academic research but was apparently written in 1999 so may already be outdated.
One thing I would add is that the EMH also suggests it’s often not super high cost to deviate: small investors can lose out by paying extra fees and taxes, spending time out of the market, and taking too much or too little over risk (and especially too much uncompensated risk from under diversification), but given the EMH they also can’t actively pick equities with expected underperformance.
It doesn’t suggest that. Factually, we know that a majority of investors underperform indexes.
When there’s an event that will cause retail investors to predictively make bad investments some hedge fund will do high frequency trades as soon the event becomes known to be able to trade the opposite site of the trade.
All events that cause more retail investors to buy a stock then it cause retail investors to sell the stock needs some hedge fund or bank to take the opposite side of the trade and likely that hedge fund or bank is in the trade because it has models that suggest it’s a good trade for them.
A hedge fund that provides liquity to trades is going to make as much money under EMH as it cost to do the market making when it competes with other hedge funds.
It worth noting that a targeted date index fund does make predictable trades where someone needs to do the market making and will likely make a small profit for doing the market making.
It doesn’t suggest that. Factually, we know that a majority of investors underperform indexes.
Absolutely, I mean that when you break out the causes of the underperformance, you can see how much is from spending time out of the market, from paying high fees, from excessive trading to pay spreads and capital gains taxes repeatedly, from retail investors not starting with all their future earnings invested (e.g. often a huge factor in the Dalbar studies commonly cited to sell high fee mutual funds to retail investors), and how much from unwittingly identifying overpriced securities and buying them. And the last chunk is small relative to the rest.
When there’s an event that will cause retail investors to predictively make bad investments some hedge fund will do high frequency trades as soon the event becomes known to be able to trade the opposite site of the trade.
I agree, active investors correcting retail investors can earn normal profits on the EMH, and certainly market makers get spreads. But competition is strong, and spreads have been shrinking, so that’s much less damaging than identifying seriously overpriced stocks and buying them.
Active investors need to spend money to hire analysts, build computer models and high-frequency trading computers.
Let’s say it costs $10 dollar/per trade to do the analysis to be able to do a trade with a retail investor that nets the hedge fund $10.10. Even when there’s no strong competition with other hedge funds over that $0.10 of profit, the retail investor is still screwed by a significant $10.10.
Otherwise, a hedge fund could make huge profits by just doing the opposite.
Do we know that this isn’t currently happening, i.e. that observing what retail investors buy and betting against them isn’t a major profit stream for hedge funds?
Sure, it’s part of how they earn money, but competition between them limits what’s left, since they’re bidding against each other to take the other side from the retail investor, who buys from or sells to the hedge fund offering the best deal at the time (made somewhat worse by deadweight losses from investing in speed).
Thank you, I enjoyed this post.
One thing I would add is that the EMH also suggests one can make deviations that don’t have very high EMH-predicted costs. Small investors do underperform indexes a lot by paying extra fees, churning with losses to spreads and capital gains taxes, spending time out of the market, and taking too much or too little over risk (and especially too much uncompensated risk from under diversification). But given the EMH they also can’t actively pick equities with large expected underperformance. Otherwise, a hedge fund could make huge profits by just doing the opposite (they compete the mispricing down to a level where they earn normal profits). Reversed stupidity is not intelligence. [Edited paragraph to be clear that typical retail investors do severely underperform, just mainly for reasons other than uncanny ability to find overpriced securities and buy them).]
That consideration makes it more attractive, if one is uncertain about an edge, to consider investments that the EMH would predict should be have very modest underperformance, but some unusual information would suggest would outperform a lot. I was persuaded to deviate from indexing after seeing high returns across several ‘would-have-invested in’ (or did invest a little in, registered predictions on, etc) cases of the sort Wei Dai discusses. So far doing so has been kind to my IRR vs benchmarks, but because I’ve only seen results across a handful of deviations (one was coronavirus-inspired market puts, inspired in part by Wei Dai and held until late March based on a prior plan of letting clear community transmission in the US become visible), and my understanding from colleagues in the pandemic space), the likelihood ratio is weak between the bottom two quadrants of your figure. I might fill in ‘deluded lucky fool’ in your poll. Yet I don’t demand a very high credence in the good quadrant to outweigh the underdiversification costs of using these deviations as a stock-picking random number generator. That said, the bar for even that much credence in a purported edge is still very demanding.
I’d also flag that going all-in on EMH and modern financial theory still leads to fairly unusual investing behavior for a retail investor, moreso than I had thought before delving into it. E.g. taking human capital into account in portfolio design, or really understanding the utility functions and beliefs required to justify standard asset allocation advice (vs something like maximizing expected growth rate/log utility of income/Kelly criterion, without a 0 leverage constraint), or just figuring out all the tax optimization (and investment choice interactions with tax law), like the Mega Backdoor Roth, donating appreciated stock, tax loss harvesting, or personal defined benefit pension plans. So there’s a lot more to doing EMH investing right than just buying a Vanguard target date fund, and I would want to encourage people to do that work regardless.
Seconding this. It turns out that investing under the current academic version of EMH (with time-varying risk premia and multifactor models) is a lot more complicated than putting one’s money into an index fund. I’m still learning, but one thing even Carl didn’t mention is that modern EMH is compatible with (even demands) certain forms of market timing, if your financial situation (mainly risk exposure through your non-investment income) differs from the average investor. This paper gives advice based on academic research but was apparently written in 1999 so may already be outdated.
It doesn’t suggest that. Factually, we know that a majority of investors underperform indexes.
When there’s an event that will cause retail investors to predictively make bad investments some hedge fund will do high frequency trades as soon the event becomes known to be able to trade the opposite site of the trade.
All events that cause more retail investors to buy a stock then it cause retail investors to sell the stock needs some hedge fund or bank to take the opposite side of the trade and likely that hedge fund or bank is in the trade because it has models that suggest it’s a good trade for them.
A hedge fund that provides liquity to trades is going to make as much money under EMH as it cost to do the market making when it competes with other hedge funds.
It worth noting that a targeted date index fund does make predictable trades where someone needs to do the market making and will likely make a small profit for doing the market making.
Absolutely, I mean that when you break out the causes of the underperformance, you can see how much is from spending time out of the market, from paying high fees, from excessive trading to pay spreads and capital gains taxes repeatedly, from retail investors not starting with all their future earnings invested (e.g. often a huge factor in the Dalbar studies commonly cited to sell high fee mutual funds to retail investors), and how much from unwittingly identifying overpriced securities and buying them. And the last chunk is small relative to the rest.
I agree, active investors correcting retail investors can earn normal profits on the EMH, and certainly market makers get spreads. But competition is strong, and spreads have been shrinking, so that’s much less damaging than identifying seriously overpriced stocks and buying them.
Active investors need to spend money to hire analysts, build computer models and high-frequency trading computers.
Let’s say it costs $10 dollar/per trade to do the analysis to be able to do a trade with a retail investor that nets the hedge fund $10.10. Even when there’s no strong competition with other hedge funds over that $0.10 of profit, the retail investor is still screwed by a significant $10.10.
Do we know that this isn’t currently happening, i.e. that observing what retail investors buy and betting against them isn’t a major profit stream for hedge funds?
Sure, it’s part of how they earn money, but competition between them limits what’s left, since they’re bidding against each other to take the other side from the retail investor, who buys from or sells to the hedge fund offering the best deal at the time (made somewhat worse by deadweight losses from investing in speed).