But, is studying and learning about investments a waste of time? Is it even possible to outperform or beat the market?
Whether you realize it or not, your answers are based on your beliefs and money mindset. In addition, if you’re investing in efficient or inefficient markets.
Many buy-and-hold investors believe that it’s very unlikely to earn consistent investment returns above key benchmarks, like the S&P 500 or Dow Jones Industrial Average (DJIA). They trust that over the long term, investing in these indices is their best option because financial markets are efficient.
The concept above comes from the Efficient Market Hypothesis (EHM) or Theory. It’s an economic belief that attempts to explain why financial markets behave in the way that they do.
Efficient market supporters believe financial markets operate in a systematic way and under certain assumptions. Their first assumption is that the current prices of assets reflect all available and relevant information. Also, they assume all investors receive the same information, at the same time, and that it’s available to everyone. They believe that all investors will act similarly and rationally based on the data they get, too.
For example, imagine two people are looking to buy stock in ABC Company. If they both buy it at the same time, then there is no way for one to gain an advantage over the other. They’ll both pay the same price because the market is operating efficiently.
One reason that insider trading is illegal is that it undermines the EMH. The people engaged in this activity are buying and selling assets based on private information, not knowledge that’s publicly available which gives them an unfair and illegal advantage over others.
The EHM also explains why many investors choose to buy passively managed index funds and ETFs. They believe that the larger total expense ratios charged by actively managed funds aren’t worth it because the market can’t be beaten.
Passive investors have good reason to be skeptical of active management, too. One article on CNBC shows that over 92% of large-cap actively managed funds underperformed the S&P 500 over a 15 year period. Yet, 8% were able to, which raises questions about how efficient markets really are.
The EMH states that it’s impossible to beat the market. Yet, we know that some people do.
Take Warren Buffet for example. Since 1965, his company Berkshire Hathaway has averaged 20% annual returns while the S&P’s has been 10.2%. His performance has been almost twice that of this benchmark’s average for over the last 55+ years, giving him good reason to be named one of the Greatest Investors of All Time!
Also, efficient markets believe that investors will behave in similar ways. But, we’ve learned in previous articles that everyone has their own money personality and mindset which impacts the way they use their resources. Further adding doubt that everyone will react consistently based on the data they receive.
The EMH isn’t 100% reliable which means assets can’t function in entirely efficient markets. Instead, some tend to operate more inefficiently than many people think!
According to Economic Theory, inefficient markets exist when asset prices don’t accurately reflect their fair or true value. This can occur when investors are interpreting information differently, don’t have access to the same information, or aren’t being completely logical. In some instances, they may be buying and selling based on their emotions’ all of which can cause assets to become under or overvalued.
Assets that get bid up higher and higher can become overvalued and potentially form a bubble. This happens when asset prices rise significantly in a short period of time while their values aren’t supported by the increase. As a result, these assets become overvalued because people are paying more for them than their true worth.
At some point, investors realize prices don’t accurately reflect true values which cause them to sell and the bubble to burst. When this happens, prices quickly fall and if the bubble is large enough, it may even trigger a financial crisis!
The EMH attempts to explain why asset prices rise and fall. During a crash, those who believe in efficient markets would credit the decline to new information becoming available, leading investors to sell. While people who believe in inefficient markets would conclude that speculators bid prices up too fast and that the true values didn’t exist to support them.
Regardless of your view, once asset prices begin to tumble and fall far enough, they become undervalued. These represent market inefficiencies because the market has priced them below their true value and now you can buy them at a discount!
Investing in more inefficient markets or those that have more market inefficiencies will give you the best buying opportunities. They allow you to purchase below the asset’s true value, immediately giving you equity!
But before you buy any asset, you need to make sure it fits into your investment criteria and helps you achieve your financial goals!
All financial markets don’t operate in either a completely efficient or inefficient manner. Yet, some markets have more inefficiencies than others, allowing you to take advantage of them and legally profit!
The best way to illustrate market inefficiencies is by looking at an example. Let’s assume that you can invest in stocks or real estate. The stock market operates in a much more efficient market than real estate because everyone that buys stocks has to do so through an exchange, like the New York Stock Exchange, Nasdaq, or Chicago Mercantile Exchange.
On any given day, there are millions of people active in the market who are buying and selling stocks. On top of that, there are tens of thousands of analysts reviewing data; both of which reduce your chances of finding market inefficiencies and profiting.
However, real estate is different. It doesn’t have close to the same amount of volume or people transacting every day. Also, unlike stocks, properties don’t have to be bought and sold using an exchange, either.
While it’s common for most people to buy real estate using a financial professional via an exchange, like the MLS, it’s not the only way. You can also purchase properties that are listed for sale by the owner or ones that no one else even knows are available for sale!
Most seasoned real estate investors prefer to buy deals that are ‘off-market.’ Through their marketing efforts, they’re able to find properties that are for sale that no other investors know about. Often, this makes them the only potential buyer which makes it more likely they’ll be able to negotiate with the seller, take advantage of market inefficiencies, and buy at a discount!
The value or the price you pay is more subjective in more inefficient markets, too. With stocks, value is set by the current bid price and everyone pays the same amount. But in real estate, buyers and even appraisers can value the same home in completely different ways based on its location, upgrades, and finishes!
For example, imagine that two different buyers are looking at the same home. One of them is in love with the kitchen while the other thinks it needs to get renovated. Their difference of opinion creates a difference in the amount of money each is willing to pay. The buyer that adores the house is willing to pay much more for it than the one who thinks it needs work.
The optimal goal of personal finance is to deploy your money for its highest and best use. Where as investing’s objective is to maximize your risk-adjusted rate of return.
You increase your chances of earning higher returns by investing in assets that operate in more inefficient markets. These assets allow you to benefit from market inefficiencies and buy at a discount which furthers your journey to financial freedom at a much quicker pace!
Are you investing in more efficient or inefficient markets? Comment below.
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