Two issues with this post. 1) You have grossly underestimated your risk profile here. By way of example, in 2006 many financial institutions thought there was virtually no counterparty risk when dealing with large, established investment banks like Bear Sterns and Lehman Brothers. They turned out to be wrong. You imply that your “plausible” counterparty risk here is on the order 1%. Do you believe then that FTX is less of a source of counterparty risk than a large investment bank? Your position implies something like that. 2) There are multiple versions of the EMH, even if we allow that what you have shown here is a source of risk adjusted excess return, you would only be giving evidence against some variants of the EMH.
Alex Free
Karma: 19
The point I was trying to make here was that your space of material risks and their probabilities are much too optimistic, so your presentation here is not “Strong Evidence” that the EMH is false. (I also mentioned that, your practical form of the EMH aside, multiple variants of the EMH make this a more complicated issue than you’ve presented, but I believe I get what you’re trying to say so that’s really just a minor quibble.)
In your second paragraph you state that there are nearly risk-free trades that net at least a 5% monthly return, i.e., an Annualized Return of: (1+0.05)^12-1 = 79.6%. That’s more than 10x the last century-or-so’s return on the US stock market. That would be strong evidence indeed but I don’t think you’ve shown that. Your prediction market and crypto trades are full of risks and frictions you haven’t accounted for and your AI trade, even if we generously grant that the outsized returns weren’t at least partially attributable to other factors, is only obvious in hindsight.
Regarding your underweighted risks, other commenters have aptly pointed out some of these, e.g., cryptocurrency volatility and trade execution risk, so I’ll just focus on the counterparty risk example I selected. I completely agree that you’ve correctly identified counterparty risk as an issue, but I believe you’ve underestimated the probability of loss as well as its significance.
Prediction markets, cryptoexchanges/platforms, etc. are new phenomenon relative to the traditional financial markets. These platforms continue to experience significant problems. Take for example the current ‘significant delays’ in withdrawing funds from places like Polymarket. Will all of these people eventually get all of their money back? Maybe, but even if they do that is still a loss in terms of the time-value of money. Or, more to the point, these platforms have a disturbing history of simply losing their customer’s money to theft or simple incompetence. I don’t know how I’d go about quantifying that risk for the trades you’ve presented, but 1% strikes me as quite low—just go look at Coinbase’s recent IPO prospectus. And that would be a total loss, not 1-2% as stated in your second paragraph; so you’re people leaving VTSAX behind better size their trades appropriately or else they face significant risk of being blown up.
All that said, I agree with the central tenent of your argument that for rational, informed investors it is sometimes possible to find opportunities for risk-adjusted alpha. I would add “provided they have good reason to believe they have some kind of edge” but that’s beside the point. I do not think you have at all shown that non-professional investors are not best off with dropping their money in a low-cost index fund and forgetting it for 30 years, i.e., that your formulation of the EMH is wrong.