How to Find Inefficient Markets
Something I’ve heard many times is that the bond market, overlooked by many ordinary investors, is in fact much larger than the stock market. Through historical books like Liar’s Poker we can see that in relatively recent times, bond traders have also been able to earn better profits than stock traders. I haven’t heard much about the last decade but in the 90s LTCM and others were still taking advantage of this.
If traders are making profits by moving securities back and forth over a day, week, or month, it stands to reason that those profits come at the expense of those buying the securities without the intention to trade them, and several stories openly talk about this. Many of the big traders focus on buying and selling from larger institutions, taking advantage of better information to extract a favorable price. Despite the size of the bond market this is easier when working with one of the many unique bonds that isn’t traded a lot. This seems pretty common since there are a lot more different bonds than bond issuers (stocks). Even an ordinary investor buying or selling individual bonds from a dealer may have hidden costs.
I’m hoping this factor doesn’t affect my portfolio much. I believe large bond index funds may suffer less from trading and hidden costs but I’m not sure to what extent. But this illustrates something that is important to investors hoping to get a fair return and traders looking to make a profit. The best market for long-term investors, and the worst one for traders, is a market where there is frequent trading and many participants with access to lots of information about the securities themselves and other trades that are happening.
Which makes you wonder why so many amateurs are trying to trade stocks today. Most of the time it is the definition of a market where traders have no edge. If you want to be a trader, it would be better to look for a market where you can know more about a certain security than anyone else. And if you want to be a long-term investor without having to do a lot of research, highly transparent markets are a good sign.