Sunday, June 03, 2018

An idea so dumb, only an intellectual will believe it !

The genesis of this article came from Alvin Chow of Dr Wealth who make this quote of social media. I was once reminded of the Efficient Markets Hypothesis (EMH). On Investopedia, the definition of EMH is as follows :

"The efficient market hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information."

This theory is broken down into three sub-forms:

  • The weak form of EMH posits that past movements and volume do not affect future stock prices. Believers in the weak form do not believe in Technical Analysis.
  • The semi-strong form of EMH posits that stock prices incorporate all public stock information. Believers in the semi-strong form do not believe in Fundamental Analysis and Technical Analysis.
  • The strong form of EMH posits that stock prices incorporate all public and private information. Believers in the strong form of EMH do not even believe in insider trading !
( I used to subscribe to the weak form of EMH until really recently, making myself one of the intellectuals who believe in this theory. )

But I'm not afraid to change my ways if more profitable approaches are out there.

For the past week, I have been going to library to prepare for the talk on F.U. Money, and I have some backtesting insights that I can leave for readers of this blog that would not detract from the really interesting findings for the paying customers of this upcoming event.

In short, here's what I found :

The baseline gains you can make from the STI ETF has been around 4.4% for the past 10 years. 

If you employ a filter that chooses Singapore stocks with lowest EV/EBITDA  and then find within this universe, those with the highest ROIC, you can get a 10.63% return with a Sharpe ratio of 0.39. 

Not too bad. 

At this stage, a lot of investors will be satisfied with this filter because it can achieve decent gains. But when you combine a value measure with momentum indicator like the Relative Strength Indicator (RSI), I was able to achieve 24.89% returns with a Sharpe Ratio of 0.9. 

As all my backtests experiments span 10 years, we clearly cannot ignore some of the ideas of Fundamental analysis as well as Technical Analysis.

This makes the EMH one of those theories that is so dumb, only intellectuals will believe in them.