Reframe Finance #8

Portfolio variability, market efficiency, non-linearity

Dear friend,

Here is your weekly dose of financial wisdom.

Invest and Forget

Over a short time increment, one observes the variability of the portfolio, not the return. Our emotions are not designed to understand this.

Investors who constantly check their portfolio performance risk not only losing their time but also their sanity. Those who look too closely at randomness burn out…

The less noise, the better.

Market Efficiency

The efficient market hypothesis states that asset prices reflect available information. In other words, €100 bills laying around on the ground will not be there for long.

There are three forms of efficiency:

  • Weak form posits that asset prices reflect all historical price information. Hence, technical analysis is useless.

  • Semi-strong form says that asset prices reflect all publicly available information. Thereby, both technical and fundamental analysis are useless.

  • Strong form asserts that asset prices reflect all information.

If one were to believe that markets are fully efficient, a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts.

But is this really the case?

I would argue markets are fairly efficient given that events are quickly priced in with the help of computers that trade at an extremely high frequency.

However, there is still some bias that gives rise to irrational exuberance given that many humans invest.

Non-linearity

“It does not matter how frequently something succeeds if failure is too costly to bear.” — Nassim Taleb

Life is full of non-linear relationships and modern society is composed of numerous complex systems but our brains are designed for linear causality.

This creates a linear bias in us whereby our brains desperately try to connect unrelated dots in order to try to make sense out of life.

For example, in the world of finance, compounding is unintuitive because we are preconditioned to think that we should get an output proportional to our input.

If you want to explore this topic further, this article is insightful.

To examining the €100 bill on the ground,

Alex Vikner