Markets are not (very) efficient

In my years as a college professor, I had more than a passing acquaintance with general investment theory.  I was interested in the subject, and did well with my personal account.  Despite this success, I believed that markets were efficient.  The Efficient Market Hypothesis had gained credence in academic circles, was taught in classrooms, and earned Nobel prizes for the theoreticians.  It made its way into popular literature.  The Wall Street Journal even started a feature comparing the stock picks of experts to the stock picks generated by throwing a dart at a page of stock prices.  The darts did pretty well.  John Bogle was a pioneer with this concept, introducing the first index fund on the S&P 500.  He wrote articles and spoke in front of influential audiences, pointing out the failings of fund managers, most of whom do not beat the market averages.  Thinking that you could beat the averages by picking "hot" fund managers was misleading.  There will always be managers that will do well and managers that will not, but it is a function of randomness.  An excellent book on this subject by Nassim Taleb explained this concept in more detail.  I purchased many copies of the book and sent them to my investors so that they could begin to understand how to distinguish expected performance from past results.  Any investor could profit by reading even a small part of Taleb’s book.  It is well worth the price.

I began work in the investment business providing models and research support for options traders, market makers in the Chicago Board Options Exchange, known in the market as the CBOE (see-bow).   I  began this work for professional traders, trading their own money (and often that of backers) for their own accounts because the traders had an edge.  They bought options on the bid and sold on the offer, conferring an inherent advantage.  The traders needed modeling support and fundamental analysis of the stocks.

As I did this work, I operated with the open mind of an academic researcher.  Gradually I became convinced that there were significant market inefficiencies.  This is extremely important.  The opportunity for the investor comes when others are making mistakes.  If markets are not really efficient, there is opportunity.  The problem comes in determining the sources of the inefficiency and knowing how and when to react.

This concept is crucial to investment management.  If markets are efficient, managers could not show excess returns.  I learned that individual investors made many mistakes, and that their personal accounts showed about half of the gains of the market averages.  They would indeed do better to buy an index fund.  I also learned that the recommendations of analysts at the major firms were a contra-indicator, even though followed by many institutional investors.  The premise was simple:  If the analysts were all in favor of a stock, their followers were already all-in.  The key was to find great stocks that were currently unloved by the analyst community and by individual investors.

I reached this conclusion long before the recent disparging of analyst research, assorted scandals, and the like.  My investors enjoyed great returns from following a contrarian strategy.  The gains did not always happen over night, but they came with time.

I intend to elaborate on this concept, the source of the inefficiencies, why they occur, and what opportunities results.  But first, I need to elaborate on the evidence that markets are not really efficient.  It is a difficult but important concept.

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