Getting Beyond the Efficient Market Hypothesis

. August 27, 2011
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If you're beginning to question the efficient market hypothesis and the buy-and-hold investing style it engenders, here are some links to whet your appetite for further research. They're organized from tame (Eugene Fama) to positively frightening (irrationally mispriced options).

"Markets are Efficient, but Investors are Under-Diversified"

Eugene Fama, the father of the efficient market hypothesis, promotes maximum diversification. (I do too, but I go further than that.)

Fama is skeptical of active management, but he's convinced that the value and small-cap effects are real, as well as the benefit of diversifying into asset classes other than just U.S. stocks and bonds. By this measure, most investors are under-diversified.

He's on the board of the Dimensional family of mutual funds.

Eugene Fama's Bio at Dimensional 

"Trading Strategies Work Better than Buy-and-Hold"

This paper applies portfolio management to trading strategies instead of stocks and bonds. There are real risks that the paper doesn't deal with, especially tail risk, but it does point out that there is more diversification in trading strategies than in traditional asset classes.

Portfolio of Risk Premia

"Trading Strategies Work, and Normal People Can Use Them" 

Some trading strategies have become so easy to apply that they are now asset classes in their own right, with diversification benefits that are realistic for small traders to access.

The Betafication of Alpha

S&P Makes the News... with a Trend-Following Index 

"Investors Irrationally Overpay for Protection Against Crashes"

The Crash of 1987
People overpay for the protection afforded by index options. This is inconsistent with their high exposure to stocks and lack of diversification.

This first summary is dated and doesn't have any major bear markets. It does, however, include the crash of 1987. The paper itself is an interesting read.

Why are Put Options So Expensive?

The second summary includes the dot-com crash. The two underlying papers include an interesting analysis of tail ("jump") risk as well as investor risk-aversion and whether these justify high option prices.

Abnormal Returns from Selling Index Put Options?

The third article looks at the Japanese Nikkei index, which has been in a secular bear market for the entire (short) period of the study. The results are surprising.

Scandalously profitable option selling on the Nikkei 225
What Now?

I use some of the strategies mentioned in the papers and articles above. However, you don't have to do this level of research to be moderately successful. Start with momentum.