Home > Uncategorized > Efficient Markets Are Impossible And This Is Bad For Traders

Efficient Markets Are Impossible And This Is Bad For Traders

December 3, 2012 Leave a comment Go to comments

One of the premises of index investing, which is my primary strategy, is that markets are generally efficient. If this is true then the best price for any tradable asset is the current price, and it’s impossible to accurately forecast a higher or lower price in the future. The idea is frequently attacked on the basis that investors don’t have perfect information and rational behavior. This is certainly a big flaw. But even in a world of perfect investors, the markets would not be efficient.

The reason is that investors have different needs and goals. A pension plan that needs to pay benefits for the next 30 years will buy 30-year bonds even if the yields aren’t great. An individual investor who needs 10% returns to make their retirement plan work will sell those bonds if the yield is too low or interest rates are likely to rise.

Moreover, the demand for various risk/return profiles will continuously shift as the finances of each person and organization change. So you can’t just figure out who else is in the market and then expect that to stay the same. To make things even more variable, the trades made on any given day are from only a small portion of the market participants and don’t fully represent everyone’s opinion. Most of the time I don’t even know the current price of my holdings. I might trade a lot more if I did.

To take a concrete example, I recently read a private economics report that forecasted the US dollar will grow stronger over the next 5 years, in part due to increasing oil and gas production that reduces the need for imports. This is just about as obvious as the number of protests for any new pipeline. So how could someone forecast an obvious future price change when rational investors would already have built that into the price?

One possible reason is that many people actually trading the US dollar today might have needs that don’t extend to the next 5 years. If they’re buying US dollars to pay a contract next month, they don’t care that it will be worth more in 5 years. Due to random circumstances there might be a surge of selling on one day that drives down the price for no good reason. My business gets a lot of income from the US but I don’t speculate much on the future exchange rates because that income is needed to pay expenses in Canadian dollars today.

For similar reasons, housing markets can be more predictable than financial markets. Due to the limitations on individuals owning many houses in one city, and the fact that larger investors and businesses don’t want to own a bunch of single-family homes all over the place, facts about the housing market can be known well before they have their full impact on the prices.

It’s hard to say how these factors play into prices since there are many different participants with different intentions and we only know a few of them. As usual, being a contrarian helps if you can actually figure out what the popular opinion driving the market is. When mutual fund managers have an urgent need to dump an unpopular stock before it shows up on their year-end report and gets them fired, you can come in with a 30-year perspective and pick it up at a discount. An even simpler way is to identify temporary desires. If everyone desperately wants to get rid of European stocks this month, then helping them with that need is like selling shovels in a snowstorm.

On the other side this seems like very bad news for traders. They typically focus on short-term profits and trends which is where most other market participants seem to make their decisions. As a result short-term trading can only get more competitive and even successful strategies are likely to eventually wipe out all past gains like LTCM ended up doing.

If the market is focused more and more on short-term results this is good for long-term investors. When I hear that people are dumping stocks because of a few bad years I get excited about the buying opportunities. All investors need to understand their needs and preferences and know how to take advantage of a good deal when they see one. At times other peoples’ different needs will make those deals available. A good deal could last anywhere from a few hours to a decade.

Even though this seems to show that stock picking works, it’s good for index investors because it shows that the index can be bought at a discount and with far less research than stock picking requires. And it might have another ironic result: active managers who claim to run circles around boring old pension funds might actually be giving away their clients’ capital to the investors with a longer perspective.

If you really want to beat the market it seems like the best strategy is to do your research to see where others are wrong and then make long-term decisions instead of being a day-trader. In other words Warren Buffet is right once again.

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