Using extrapolation to debunk the Efficient Market Hypothesis

January 16, 2018  ●  2-minute read

This year, I’ve changed my performance tracking method from an internal rate of return to a time-weighted return. The main reason for the change is that I found a free spreadsheet online for tracking investments. My self-built 10-year-old spreadsheet is getting unwieldy.

It’s easier to calculate a time-weighted return with the new sheet’s layout than it is an internal rate of return. The second benefit is that my investment results will be directly comparable to professional managers.

What is a time-weighted return?

With a time-weighted return, a holding period return is calculated for each day. And then those daily holding period returns are multiplied together to find a holding period return for all of the past days in the current year. By the end of the year, the time-weighted return will equal the annual return for the portfolio.

The big advantage of a time-weighted return is that the daily return is calculated without the skewing effects of cash contributions and distributions. It’s a true reflection of the actual investment results.

What are my daily returns?

Out of curiosity, I annualized each day’s holding period return and the total YTD return as each day passes. The results were revealing. Anyone that believes in the Efficient Market Hypothesis must have never annualized daily holding period returns.

Here are the first 15 days of 2018:

Day Daily Return (%) Daily Annualized (%) YTD Return (%) YTD Annualized (%)
1 -0.12 -36 -0.12 -36
2 0.06 26 -0.06 -10
3 0.69 1137 0.63 115
4 0.12 55 0.75 98
5 -0.27 -62 0.48 42
6 0.00 0 0.48 34
7 -0.09 -28 0.39 23
8 -0.18 -49 0.21 10
9 0.67 1038 0.88 42
10 0.59 741 1.47 70
11 1.06 4605 2.54 130
12 -0.98 -97 1.53 59
13 -0.01 -2 1.53 53
14 0.25 151 1.78 59
15 -0.37 74 1.41 41

According to the Efficient Market Hypothesis, the stock market incorporates all known information into all stock prices in real-time. It’s impossible to beat the market because of its omniscience.

If that were true, then in the first fifteen days of 2018, the true value of my portfolio fluctuated between -97% and +4,605%. Through 2017, my 10-year average return was 11% per year. So do these variations in portfolio value sound correct?

Uh… no.

If the stock market is omniscient, why is it changing its opinion of my portfolio within a range of almost 5,000%? The answer: the stock market is not omniscient, nor efficient. (But it is worth noting how temperamental and mood-swingy it is.)

What about the annualized year-to-date returns? Are they an better?

The best predictor of this year’s performance is my arithmetic average, which I mentioned is 11%. Efficient market proponents would agree. But then why are the annualized YTD returns so widely varied?

As the year goes on, those annualized YTD returns will get closer and closer to the mark. But the wide range in the beginning of the year makes them of only limited use. With 350 days left to go, that’s to be expected. Outside of a thought experiment like this one, I can’t think of any other reason to track them.

As of January 15th, I’m on track to make 41% this year. Woohoo! 😉

As much as I would like to believe that that’s true, history tends to repeat itself. Even though my long-term Sharpe ratio is better than the S&P 500, the annualized returns of this year’s YTD returns are nothing more than entertainment.

The only thing that can be gleaned from the current results is that the trend in the first two weeks of the year is up.

The EMT: I just don’t get it

If anyone can believe in the Efficient Market Hypothesis before looking at those results and still believe in it after, I think it shows a lack of experience in real-world investing.

But it’s a great example of cognitive biases.

Posted in: value investing