Podcast 2: Jan. 15, 2010
Are Inefficient Markets Safer?
I have received yet another email from a trader asking about a newsletter claiming to consistently generate 3% per month. While I’ve recently talked about the risk-reward connection in previous podcasts and why those returns are not consistently possible, this newsletter added a new twist. It publicizes that markets are highly inefficient and claim they have can exploit them for high-profit trading.Today I thought it would help to talk about what it means to have an efficient market and for those who strongly believe that markets are highly inefficient – the risks they pose.
So what does it mean to have an efficient market? The idea of an efficient market is a theory that says prices are not biased high or low. In other words, asset prices should not be consistently above or consistently below fair value. They should reasonably reflect all available information and therefore provide our best estimate as to a security’s value.
For instance, if Microsoft is trading for $30 then that is the consensus opinion by traders from all over the world. If enough traders think it is undervalued, its price will rise as more buyers than sellers appear. On the other hand, if enough traders feel it is overvalued, its price will fall as they will short shares seeking profits from a drop in price. But if the price stabilizes at $30 then we must reasonably say that the market feels that is the true value of the stock right now.
Of course, if we had a supreme all-knowing accountant who could verify the exact value of Microsoft, the $30 price may be a little high or a little low. But when we look at the prices of all securities, we should not see them consistently above or below their theoretical value. On average, they should reflect all available information.
To better understand the efficient market theory, observe what happens on the highway the next time you’re driving home in rush-hour traffic. Assume you’re on your way home from work, creeping along in five o’clock traffic. In order to get home quicker, you’ll closely watch the left and right hand lanes to see if one seems to be moving faster. After a few moments, you decide…the left lane is faster so you decide to switch to that lane. However, the moment you do, that lane gets a little slower and the lane you gave up becomes a little faster. By switching lanes, you’re adding to the congestion of that lane and reducing it from the lane you were in. The apparent advantage of the left lane has now been slightly reduced. The apparent disadvantage of your former lane has been improved.
However, you’re not the only driver on the road. After all, that’s why it’s rush-hour traffic. Every driver is doing the same thing as you and watching closely for small opportunities to speed up and get home quicker.
That means, the very moment you decide to jump into the left lane, chances are a lot of other drivers will do the same thing. They all observed the same thing as you. The small advantage you initially observed is quickly diminished.
The point is that eventually all lanes will be moving about the same speed. And the reason, again, is that you have many drivers sharing one common goal – to get home as quickly as possible.
Now, would the efficient market theory claim that all lanes in rush-hour traffic must move exactly the same speed and tell you it’s not worth your time to watch for opportunities? Not at all. If drivers firmly believed that all lanes must move identically fast and could never deviate from perfection, there would be no incentive for them to look for slightly faster lanes – and no reason for them to retain identical speeds. If no drivers are watching, there could easily be large differences in the speeds of the various lanes.
Therefore, traffic speeds in rush-hour traffic must get unbalanced just enough to make it worth a driver’s time to switch lanes. There just shouldn’t be any glaring differences in speeds.
The financial markets work in a similar fashion. Instead of drivers trying to reducing their time home, you have investors seeking returns, or profits, from securities. If a stock appears cheap, traders buy it. If it appears expensive, they sell it. The constant buying and selling pressures are the equivalent to changing lanes in traffic.
As traders buy shares, the price rises and the potential profit drops. If they short it, the price falls and the potential profit rises. The buying and selling pressures tend to equalize all risks.
The main point to understand is that prices of securities should reasonably equalize. That doesn’t mean they should all be the same price. Instead, they should be priced according to the risk they pose. All securities within a given level of risk should be expected to generate the same returns, on average.
That’s simply all the efficient market theory says.
Another interpretation of the efficient market theory states that you cannot beat the market by using information the market already knows. It is therefore impossible to consistently beat a broad-based index such as the S&P 500 by simply watching CNBC, reading Forbes magazine, or looking at past prices. The market already knows that information and the value is factored into today’s price.
Using our driving analogy, the efficient market theory states you cannot consistently drive home faster in rush-hour traffic by listening to traffic reports or by studying which lanes had accidents yesterday. The moment a newscaster reports an accident at Exit 50, for example, all cars in that area were already changing lanes. That’s the reason it made the news. The radio announcer didn’t predict there would be an accident; he simply reported what has already happened. That’s true for the financial media. The second you hear that ABC stock has just received a large contract that is surely going to increase its price, the event has already occurred. Investors have already priced that into the security and the news is simply reporting what happened in the past.
That’s simply the essence of the efficient market theory. It’s reasonable. However, people try to take it to the extreme and say the market is not perfectly efficient so therefore it has no bearing on reality whatsoever. They believe (or perhaps just try to sell you on the idea) that markets are highly inefficient and therefore there is lots of money to be made – easily and without risk.
If markets are highly inefficient then there is, no doubt, some easy money to be made. After all, it is easier to make money when big price discrepancies exist, which is the definition of an inefficient market.
But that brings us to one of the most important points of today’s podcast: If you believe that markets are highly inefficient and there’s easy money to be made, that’s fine. Just be sure you understand the corollary: Inefficient markets also make it easier…to lose. Why is that?
An inefficient market means that information is somehow not being disseminated. It’s not being factored into the security’s price. If it’s not being factored into the price, you have less confidence that the price you’re paying is fair based on available information. If you have less confidence, you therefore have more risk. So if markets are highly inefficient as many believe, the high trading profits they claim to generate are not because the money is easy; it’s because the risk is greater.
Remember though, all purchases and sales – even if markets were highly inefficient – moves them towards efficiency just as changing lanes in traffic tends to equalize all speeds. The fast lanes get slower and the slow lane gets faster. Markets must provide small pockets of inefficiencies to make it just worthwhile someone’s time to correct for it. But they will never be out of line to guarantee big profits – and especially for no risk like so many people believe. They cannot remain inefficient indefinitely. To believe they can is to believe there will always be one lane that moves faster in rush-hour traffic regardless of how many drivers switch to that lane. But that belief contradicts reality when you consider that rush-hour traffic exists for a reason: There is no faster lane.
Likewise, markets remain reasonably efficient because many traders are watching and acting on the same opportunities. The few financial opportunities that are not correctly priced get quickly taken just as fast lanes quickly get occupied. Drivers who find small benefits of changing lanes only decrease the time slightly. Likewise, traders who may find small pockets of inefficiencies can increase their returns slightly. If that is beginning to make sense then it should be evident that no trader can consistently make 3% per month, which is more than 42% per year, for little risk.
Rather than seeking abnormally high returns for no risk, it makes much more sense to find opportunities and hedge the risks you wish to avoid. Let the returns fall where they may. And the only way to do that is with options. If you’d like to learn more about options, I have a free course on my website at options A to Z.com. Just click on “classes” and then “exploring the world of options.”
Options trading and investing can be very rewarding but you must understand all of the fundamentals in order to master the art and science of options trading. For those who would like to advance their knowledge, you may wish to consider the Alpha Trader Certificate Course and Strategy Lab.
Knowledge is a risk-free investment and understanding the difference between efficient and inefficient markets and why neither condition makes it easy to generate profits can only make you better at the art and science of options trading.