Market Inefficiencies: Exploring Examples, Trading Strategies, Edges, and Opportunities in Stocks
Is it possible to find market inefficiencies when trading or investing? Yes, it’s possible to find inefficiencies in the markets. However, if you want to consistently make money in the stock markets, you need to understand how the markets work. Are you the prey or the predator? Are you street smart or academic smart?
Inefficiencies are rare and require backtesting, knowledge, and labor-intensive work. In this article, we discuss what market inefficiency is, how you exploit inefficiencies, and we discuss which markets are most efficient and inefficient. We end the article by suggesting how you go about looking for inefficiencies.
What are the three forms of market efficiency?
The efficient-market theory asserts that there is no way to gain superior performance (that is, extra returns) for a given level of risk. Unfortunately, according to academics, the only way to gain an extra return is to take on more risk.
There are three forms of market inefficiency:
Weak Form
The weak form states that all prices have discounted past data and thus technical analysis is futile. However, fundamental analysis works under a weak form of efficiency.
Semi-Strong Form
The semi-strong form states that all public information is reflected in the prices, and thus both technical and fundamental analysis is a waste of time and will not work.
Strong Form
The strong form goes one step further and includes not only public information, but also non-public information. Thus, there is no way anyone can get an edge, not even insiders.
With a strong form of efficiency, no one can get abnormal returns.
Paul Samuelson, the winner of the Nobel Prize in economics, explains market efficiency much better than we do in this paragraph:
If intelligent people are consistently shopping around for good value, selling those stocks they think will turn out to be overvalued and buying those they expect are now undervalued, the result of this action by intelligent investor will be to have existing stock prices already have discounted in them an allowance for their future prospects. Hence, to the passive investor, who does not himself search out for under- and overvalued situations, there will be presented a pattern of stock prices that makes one stock about as good or bad a buy as another. To that passive investor, chance alone would be as good a method of selection as anything else…..
Is the efficient market hypothesis true? Are capital markets efficient?
Let’s start by quoting the greatest investor of all time, Warren Buffett:
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical………I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards.
Warren Buffett wrote those words some decades back in an article about his friends from the 1960s and 70s (The Graham Group – renamed after Benjamin Graham).
As a matter of fact, he was so offended by the academics that he kept them on a dartboard on the wall. He and Munger saw these academics as holders of witch doctorates. Their theories offended Buffett’s reverence for rationality and for the profession of teaching.
Buffett is, of course, partly right. As far as we can see, there are opportunities to reap abnormal rewards, but they are not abundant, to say the least. Another proof that it can be done is Jim Simons’ Medallion Fund:
Unfortunately, these are the exceptions. Based on an index the returns are like a zero-sum game. Some win, some lose, but in aggregate, all can’t be winners.