Take Advantage Of Inefficiencies In Stock Prices

October 22, 2013 9:46am ETF BASIC NEWS

warren-buffett: This week the Royal Swedish Academy of Sciences awarded the 2013 Nobel Prize to three deserving American economists: Eugene Fama, Lars Peter Hansen and Robert Shiller. Fama, of the University of Chicago, famously wrote the


1965 paper “Random Walks in Stock Market Prices,” demonstrating that the stock market is highly efficient at rapidly pricing all publicly available information into stock prices.

How does this happen? Simple. Every day, investors, analysts and other curious people are out there talking with employees, suppliers, customers and competitors of publicly traded companies. The information they glean as rational, self-interested individuals filters into the stock market through their buying and selling decisions.

A Sensible Strategy

Burton Malkiel took this knowledge and turned it into a classic investment book, A Random Walk Down Wall Street, where he argued that it is not only futile but nearly impossible to beat the stock market averages over the long term.

Vanguard founder John Bogle, in turn, took these insights and created the first S&P 500 Index Fund, an easy way to track the market’s performance with minimal expenses or annual tax consequences.

Much of what Fama, Malkiel and Bogle have done is smart and sensible. In fact, I used part of their findings to write a book, The Gone Fishin’ Portfolio, showing investors how to create a diversified low-cost, tax-efficient portfolio for superior long-term growth.

A Gone Fishin’ strategy should be the core of your investing approach. But, ideally, it should not be your entire portfolio. Why? Because there are serious flaws in the “efficient market theory,” and you can capitalize on them to create sizable additional profits. Here’s how…

You Can Beat the Market

Yes, the stock market is highly efficient at pricing in all publicly available information. But it is not perfectly efficient. There is a big difference between saying “most stocks are efficiently priced most of the time” and “all stocks are efficiently priced all the time.”

If stocks perfectly reflected the business prospects of every public company all the time, you would never have heard of Warren Buffett, John Templeton, Peter Lynch or Carl Icahn. These men have beaten the market by a wide margin over the long haul by taking advantage of inefficiencies in stock prices.

(The independent Hulbert Financial Digest confirms that The Oxford Club has beaten the market by a substantial margin for more than a decade now, too.)

In addition to everyday market inefficiencies, it’s important to recognize that while investors are always self-interested, they are not always rational. A glance back at history shows that at major market peaks they are too optimistic and complacent, and at market lows they are too pessimistic and fearful.

These periods provide superb buying and selling opportunities for the contrarian investor.

How do efficient market theorists respond to these counterarguments? Incredibly, by claiming that bubbles can only be recognized in the rearview mirror. In 2010, for instance, Mr. Fama told The New Yorker magazine, “It’s easy to say prices went down, it must have been a bubble, after the fact. I think bubbles are twenty-twenty hindsight.”

Irrational Exuberance

Gimme a break. At the very height of the Internet bubble, I worked at a Wall Street firm whose shares skyrocketed when we announced that we were unveiling the world’s first global Internet-based stock trading platform. (Anyone who inquired would have learned that we had done nothing more than hire a webmaster.)

Because employees were not allowed to sell their pension shares until they left the company – and since I had more shares in the pension than any other employee – I quit, even though I had been there 14 years, just so I could dump my shares. It was a good move. They soon plunged 90%, along with the rest of the Internet sector.

Likewise, at the peak of the housing bubble, while excited home-flippers reminded us “they’re not making any more land” and “real estate always goes up,” I editorialized repeatedly that home prices were beyond logical justification and, in fact, had already been falling in Japan for 13 years.

I was hardly alone in these insights, of course. Bubbles are created when extreme optimism meets sky-high valuations. And you don’t have to practice the dark arts to recognize them.

In sum, winners of the Noble Prize in Economics are generally academics, not businessmen or market mavens. (How else can you explain Paul Krugman?) So adopt the best part of their ideas and jettison the rest.

Specifically, let low-cost index funds form the conservative foundation of your investment portfolio, then boost your returns further by owning inefficiently priced individual stocks.

If you’re successful – as we’ve been at The Oxford Club for more than 13 years – your future returns will be substantially higher.

Good investing,

by Alexander Green, Chief Investment Strategist, The Oxford Club

Investment U provides cutting-edge research and strategic financial recommendations for all levels of investors through its morning publication Investment U Daily and its related publications.


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