If a market is efficient, the prices of investments adapt very quickly and accurately to new information. In fact, prices change so quickly in such a market that it is impossible for investors to make a profit by knowing a lot about an investment. As a result, people investing their money in an “efficient” market are surprisingly restricted in the way that they can earn more money. In an efficient market, the only way a person can make more money is if he or she takes on more risk. Say, for example, that I know a lot about investing in a specific sector. Let’s even say that it is an obscure sector, like the manufacturing of dolls. After researching the bustling doll sector, I find out about a doll manufacturing plant in Omaha, which has publically announced a change in its manufacturing technique.
I realize, with my expertise, that this manufacturing change will increase the value of the company by four times. Last week, before the announcement, the company’s stock was trading at $5.00 per share. When I rush to place a buy order right after the announcement, however, the stock price has already risen to $20.00 per share and I cannot make my abnormally high profit. The price already reflects the new value of the company because it adapted instantly and accurately.
In an efficient market, this will always happen because information about each investment is spread so broadly across the market that anything one investor knows, everyone knows.
Risk Is Worthy Of Rewards
Everyone who invests their money, from the casual e*trader to the investment banker, is faced with the choice of whether to be in the “inefficient market camp” or the “efficient market camp”. Is it smart to invest with active managers (mutual funds, hedge-funds, brokers) who take a fee in exchange for their expertise in investing clients’ money? Or is it more prudent to invest only in passive portfolios (ETFs and indexes) because any supposed expertise has no value in investing? Is it necessary to make risky decisions if one wants to make more money? These are questions that all people face.
We all want to earn money with our investments but very few of us want to increase our chance of losing money in the process. For this reason, earning higher risk-adjusted returns is the goal of every intelligent investor. Higher risk-adjusted returns occur when people get higher returns without taking on more risk or the same returns while taking less risk. They occur when investors get more bangs for their buck.
One way to earn higher risk-adjusted returns is by having the proper asset allocation and diversifying. If markets are efficient, implementing a proper asset allocation and diversifying is the only way to earn higher risk-adjusted returns.
The other way to earn higher risk-adjusted returns, which is only possible when markets are inefficient, is by consistently picking investments which can be bought for less than their intrinsic value. Such investments have upsides that are disproportionately high compared to their downsides. The ability to find these investments is often called “security selection” and describes what most people picture when they think of investment skill. Even with certified document translations available for those investing in various markets, keeping perspective on security selection involves a deep understanding of individual investments and the nature of financial markets.
Earning higher risk-adjusted returns with superior security selection is not possible in an efficient market because investing knowledge is considered to be so well diffused across the market that it is useless. In contrast, inefficient markets allow investors to find mispriced assets and then wait for the market to “correct”, earning higher profits in the process.
Thankfully, investment skill is, in fact, useful because markets are not always efficient. It is useful to note here that an inefficient market is not inaccurate but just slow. In the long-term, prices will reflect the intrinsic value of investments despite market inefficiency. In the short-term, however, mispricing can persist long enough for investors to act on them and benefit in the process.