Taking Advantage of Efficient Markets’ Limitations

Modern economic theory says that capital markets are generally efficient, but to various degrees, that is. In contrast, a market is considered perfectly efficient when current prices reflect all publicly available information and when prices quickly adjust to the inflow of new information, thus maintaining an unbiased stance. In a perfectly efficient market, investment risk would be perfectly offset by receiving prices that are information based. However, we all know that there is hardly anything perfect out there, capital markets included.

One of the fallacies of a perfectly efficient market is that if new information is immediately reflected in securities’ prices, then there would be no need to analyze such information. If there is no need for analysis, then there is no need to search for new information. Finally, if new information is not analyzed, then it stands to reason that it is not reflected in security pricing either. At the “end” of this vicious circle, it becomes clear the perfect efficiency is not only lost, but is lost completely.

This is why economic theory allows for various degrees or forms of market efficiency: weak, semi-strong, and strong. I find the lessons about the strong form of efficient market most illuminating. In a strong, efficient market, all information about securities, be it public or private, is already reflected in securities’ prices. Any new information that enters the market will affect prices. However, since such information is randomly dispersed, securities’ prices also move at random.

Bear in mind that the strong, efficient market must not be equated with the perfectly efficient market because the former is riddled with interesting fallacies. For starters, studies of mountains of trading data have confirmed that on a statistically significant level, company insiders and specialists have consistently outperformed the overall market. This is because these professionals are often in possession of non-public, material information. Now, they do not have to engage necessarily in illegal insider trading to deliver better performance. Mere knowledge of companies and markets’ inner-workings is often sufficient. Yet, this would be in direct violation of strong, efficient market theory.

Research analysts, on the other hand, on average, deliver “hit-and- miss” results. They have considerable theoretical and analytical skills at their disposal, but they also have only public material information to work with (or at least they should have only such information). What is missing from the mix is inside and/or specialized knowledge. And finally, the only group confirming the

strong, efficient market hypothesis includes professional money managers, who generally offer inconsistent performances relative to markets or benchmarks.

What should my very short review of efficient market theory mean to our readers? Well, the bottom line is that if you can find superior analysts and money managers that come cheaply (no easy feat, I assure you), hang on to them. You don’t have to go at it alone. The expertise and experience of these people, some of them already working for PROFIT CONFIDENTIAL readers like you, is likely to help you make loads of money in the markets.