There’s a great article in today’s Financial Review by Phillip Baker. It touches on the old debate of whether markets are efficient or not. Or, put another way, whether markets are always right.
‘There’s an old saying that dictates the market is never wrong, that the price of any asset is in line with the basic fundamentals that are there for everyone to see.
‘There is always a reason for a good old fashioned price surge, up or down, even when nobody can find it, but it’s fair to say the “efficient market hypothesis” has been tested in 2017 with bubbles all over the place.’
Over the past few decades, behavioural economists have blown the efficient market hypothesis out of the water. Led by recent Nobel Prize winner Richard Thaler, the behavioural economists have chipped away at the edifice built by the rationalists in the 1970s.
Today, very few people believe that the market is truly efficient. It’s widely acknowledged that stock prices are the result of human decision making. And it’s widely acknowledged that human decision making has its flaws.
There’s ample evidence. There are many fund managers out there who have long term records of beating the market. If the market were truly efficient, no one would be able to beat it over the long term.
But — and this is the important point for investors — just because you know the market might be inefficient, doesn’t mean it’s easy to beat.
In fact, beating the market over the long term is a feat reserved for only a very small minority of market professionals. If you’re a part-timer, you have your work cut out for you.
With that in mind, here are a few tips to consider if you want to prove the efficient market hypothesis wrong.
This is something I’ve been thinking about and studying for the best part of 20 years. And I recently interviewed a bunch of fund managers with long term outperformance to get an understanding of what the key drivers of outperformance are.
The first thing I would say is that markets are very efficient in the short term, but not so much in the longer term. That’s because certainty recedes with time.
So I take the view that in the short term, the market is nearly always right. But in the long term…not so much. That opens up an opportunity for ‘time arbitrage’.
There are many layers to this, but suffice to say if you’re willing to take a longer view than the market, you have a better chance of outperforming.
Having said that, timing is still important. There is no point buying something just because it’s out of favour. You have to see a reason for it coming back into favour…before everyone else does.
Go out on a limb
The other thing to consider is that you can’t beat the market if you’re doing what everyone else is doing. You have to look in areas that are unpopular. You have to be prepared to take calculated risks that may seem dumb at the time.
This is difficult for many people to do. In fact, I’d say it’s amongst the hardest things for people to do. Humans have evolved to be a part of the herd. We are social animals. In evolutionary terms, going out on your own does not promote survival.
The emotional strain of going against the herd is what makes taking contrary positions so hard. Buying and holding on when everyone is doing something else (and doing it well, because in the short term the market is always right) is something we are not conditioned to do.
When I asked one of the fund managers I interviewed about how he handles the emotional aspect of investing, he said it wasn’t easy. But his job was to ‘be rational’.
I think this is a key point. The market is an emotional beast of a thing. Look at bitcoin right now. It’s a very emotional market. If you want to beat the market, you have to stay rational.
For many people, this is all but impossible. That’s because we’re human, and humans have emotions. They’re an evolutionary necessity. Learning to control them is the key.
In fact, I’m writing a book that aims, among other things, to help investors do just that. With understanding and awareness, emotions can be tamed.
What’s the secret behind the success of everyone’s favourite investor, Warren Buffett? Apart from Charlie Munger, I would say his extreme rationality. Buffett has a unique ability to stay rational in highly emotional situations.
If you’ve read Snowball, his biography, you’ll know what I mean. He comes across as an emotionless robot, to put it kindly.
With that in mind, do you really want to be Warren Buffett? Is beating the market and amassing billions worth it?
Editor, Crisis & Opportunity