Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
Gold & Silver Stand Strong amid Stock Volatility & Falling Rates - 16th Aug 19
Gold Mining Stocks Q2’19 Fundamentals - 16th Aug 19
Silver, Transports, and Dow Jones Index At Targets – What Direct Next? - 16th Aug 19
When the US Bond Market Bubble Blows Up! - 16th Aug 19
Dark days are closing in on Apple - 16th Aug 19
Precious Metals Gone Wild! Reaching Initial Targets – Now What’s Next - 16th Aug 19
US Government Is Beholden To The Fed; And Vice-Versa - 15th Aug 19
GBP vs USD Forex Pair Swings Into Focus Amid Brexit Chaos - 15th Aug 19
US Negative Interest Rates Go Mainstream - With Some Glaring Omissions - 15th Aug 19
GOLD BULL RUN TREND ANALYSIS - 15th Aug 19
US Stock Market Could Fall 12% to 25% - 15th Aug 19
A Level Exam Results School Live Reaction Shock 2019! - 15th Aug 19
It's Time to Get Serious about Silver - 15th Aug 19
The EagleFX Beginners Guide – Financial Markets - 15th Aug 19
Central Banks Move To Keep The Global Markets Party Rolling – Part III - 14th Aug 19
You Have to Buy Bonds Even When Interest Rates Are Low - 14th Aug 19
Gold Near Term Risk is Increasing - 14th Aug 19
Installment Loans vs Personal Bank Loans - 14th Aug 19
ROCHE - RHHBY Life Extension Pharma Stocks Investing - 14th Aug 19
Gold Bulls Must Love the Hong Kong Protests - 14th Aug 19
Gold, Markets and Invasive Species - 14th Aug 19
Cannabis Stocks With Millennial Appeal - 14th Aug 19
August 19 (Crazy Ivan) Stock Market Event Only A Few Days Away - 13th Aug 19
This is the real move in gold and silver… it’s going to be multiyear - 13th Aug 19
Global Central Banks Kick Can Down The Road Again - 13th Aug 19
US Dollar Finally the Achillles Heel - 13th Aug 19
Financial Success Formula Failure - 13th Aug 19
How to Test Your Car Alternator with a Multimeter - 13th Aug 19
London Under Attack! Victoria Embankment Gardens Statues and Monuments - 13th Aug 19
More Stock Market Weakness Ahead - 12th Aug 19
Global Central Banks Move To Keep The Party Rolling Onward - 12th Aug 19
All Eyes On Copper - 12th Aug 19
History of Yield Curve Inversions and Gold - 12th Aug 19
Precious Metals Soar on Falling Yields, Currency Turmoil - 12th Aug 19
Why GraphQL? The Benefits Explained - 12th Aug 19
Is the Stock Market Making a V-shaped Recovery? - 11th Aug 19
Precious Metals and Stocks VIX Are About To Pull A “Crazy Ivan” - 11th Aug 19
Social Media Civil War - 11th Aug 19
Gold and the Bond Yield Continuum - 11th Aug 19
Traders: Which Markets Should You Trade? - 11th Aug 19
US Corporate Debt Is at Risk of a Flash Crash - 10th Aug 19
EURODOLLAR futures above 2016 highs: FED to cut over 100 bps quickly - 10th Aug 19
Market’s flight-to-safety: Should You Buy Stocks Now? - 10th Aug 19
The Cold, Hard Math Tells Netflix Stock Could Crash 70% - 10th Aug 19
Our Custom Index Charts Suggest Stock Markets Are In For A Wild Ride - 9th Aug 19
Bitcoin Price Triggers Ahead - 9th Aug 19
Walmart Is Coming for Amazon - 9th Aug 19

Market Oracle FREE Newsletter

Top AI Stocks Investing to Profit from the Machine Intelligence Mega-trend

How to Profit from Inefficient Financial Markets

Stock-Markets / Financial Markets 2009 Apr 07, 2009 - 05:39 AM GMT

By: Money_Morning

Stock-Markets Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes: One of the single biggest fallacies foisted upon the investing public is the notion of an “efficient market.” Academics love it, which is why the “ efficient-market hypothesis ,” or EMH, as it's known, is taught at all the leading B-schools. The broadest version of this theory holds that securities prices already reflect all known information; EMH proponents believe it's impossible to outperform the markets over time - except by luck.


The reality, however, is that the markets are anything but efficient. In fact, not only are the markets highly inefficient, but - as many investors have learned the hard way - they are frequently completely irrational, as well.

First published in 1965 in The Financial Analysts Journal , the efficient-market hypothesis was the result of a nonsensical doctoral thesis penned by Eugene Fama . He hypothesized that the markets are characterized by multiple participants acting in a rational manner in an effort to profit. Fama believed - as the majority of EMH proponents do - that in an efficient market, competition among the participants leads to a situation where the actual prices of individual securities (stocks, bonds, exchange-traded funds, and the like) already reflect the combined total of all known information.

The bottom line: Stock prices, therefore, reflect reasonable intrinsic values at all times. [One version of the efficient-market hypothesis, the so-called "strong" version, actually holds that securities prices reflect all information - even information known only to company insiders, and to no one else out in the marketplace].

Few people understand that the belief in market efficiency - as much as any other factor - is one of the single-biggest justifications for all sorts of things that we take for granted today, including:

  • Mark-to-market accounting systems.
  • The concept of total returns.
  • Efficient frontiers .
  • And even various stock-rating systems.

Market efficiency even provides the underpinning for the so-called “ prudent man ” rules that are so critical to ERISA (Employee Retirement Income Securities Act of 1974) funds and the entire money-management industry, not to mention much of the Financial Accounting Standards Board (FASB) regulations.

Well, at the potential of really igniting an e-mail bonfire, we need to ask ourselves: If the markets are truly this efficient, why do all the research? Why would we have an entire industry of analysts who are collectively paid billions of dollars a year to ferret out information that the efficient-market hypothesis says is already reflected in current market prices? In fact, why would we even have the concept of “insider trading” to deal with or be so concerned by American International Group Inc. ( AIG ) type bonuses or even the Federal Bailouts if things were truly “known?”

The inconvenient truth is that the markets are wildly inefficient and they can be so for much longer periods of time than people realize - or that “experts” would admit.

Moreover, as my own research shows, the markets are neither one-dimensional nor three-dimensional, and they are also not characterized by “ log-normal distributions .” They are, in fact, fractal creatures that can shift from trending to non-trending in an instant. And they are increasingly characterized by something called “fat tails.”

When you hear that last term - and you will with increasing frequency in the years ahead - it will be most associated with huge market moves that had previously been unthinkable, or regarded as impossible. Nassim Nicholas Taleb does a great job of describing them as “ Black Swans ” in his book by the same name.

For most people, this will be a discussion best accompanied by a stiff drink - so you can skip the next few paragraphs if you like. The important thing to understand - and to come to terms with right now - is that the “impossible” happens a lot more than its label implies.

In recent years, people have become entirely too comfortable with the notion of “normal” markets and that's one reason why so many investors are hurting so badly now. They came into 1999, and into 2007, with portfolios that were too heavily weighted in stocks and other holdings that relied on “normal” market behavior and historical precedent. Those investors sealed their own fates by believing that the fancy diversification graphs they got from Wall Street investment houses would protect them; instead, they discovered that diversification doesn't work when everything goes down together.

It's one of Wall Street's dirtiest secrets and has emerged as one of the most hotly debated topics in Washington today.

Research (mine and that of others who are a lot smarter than I am) suggests that conventional diversification theory based on lognormal market distribution actually camouflages risk, instead of reducing it.  That's why companies such as AIG, Lehman Brothers Holdings Inc. ( LEHMQ ), and others, got into so much trouble. By placing their trust in errant models, the quants that were supposed to be protecting the hen house let in the foxes without ever realizing what they had done.

The experts' mathematical models were supposed to account for “normal” conditions. Nobody asked what would happen when the improbable black swan showed up. And if they did ask, they sure as heck didn't pay attention to the answers, because it may have ruined their plans for multi-gazillion-dollar bonuses. I can't tell you how often in recent months I've heard insiders protest with comments and observations that “the markets aren't supposed to do that.”

This is really neither here nor there though. For every day investors, the critical part to understand is that the markets are demonstrating behavior that's supposed to be impossible on a much more regular basis than people realize.

Take, for example, a November study from Cook Pine Capital LLC . Like my own research, the Cook Pine study shows that in the last 81 years of Standard & Poor's 500 Index data, so-called “ three sigma ” (or three-standard) deviations happened more than 100 times. Conventional log-normal modeling of the type AIG and others used heading into this crisis suggested that such events should have occurred only 27 times.

Oops.

And that's not even as bad as it gets.

The Cook Pine study also demonstrated that the likelihood of a four-standard-deviation move on any given day is one in 100. Yet we've seen 43 of them since 1927. And even a five-standard-deviation move, which is theoretically impossible from a statistical standpoint, has happened 40 times in the last 81 years, including eight times since September alone.

This is precisely why I frequently point out to investors that while using conventional diversification is better than nothing, it's often akin to rearranging the deck chairs on the RMS Titanic .

You're much better off just getting off the boat altogether.

The rules of money have changed and this kind of data suggests that it's how you concentrate your wealth that matters, particularly when it comes to avoiding the improbable - and even profiting from it.

One of the simplest ways to do this is through the use of non-correlated investments that zig when everything else zags. In the old days, that meant having exotic futures accounts or taking positions opposite to the markets entirely using margin accounts to sell individual stocks short - one stock at a time.

Unless you had a fair chunk of change to put into a managed account, chances were that you couldn't effectively mitigate the risk of the unknown. Of course, traditional Wall Street brokerages dismissed futures for a long time, so that didn't help. But that's another story for another day.

What matters now is that there's an entirely new class of “inverse” investments available to individual investors. Unlike managed-futures accounts, there are no account minimums and no active management fees. Most are available through online discount brokers and can be purchased just like stocks.

I've talked about these for years and I am absolutely amazed that more investors don't use them.

Actually, I'm astounded.

Inverse funds, as their name implies, go up in value when the markets go down. There are plenty of choices to consider, with everything from the S&P 500 to specific sectors available in the mix. There are even double and triple inverse funds out there, which use swaps, futures and options in a fashion that allows them to move two or three times as much as the investment vehicles to which they are linked.

Of course, if the markets go up, the reverse is true and these things can lose money in a real hurry, so one can't just pile in indiscriminately.

My research and that from groups like the CME Group Inc . ( CME ) and Chicago Board Options Exchange (CBOE) suggests that an allocation equal to 1% to 5% of your overall assets is about right when it comes to enhancing overall returns and lowering portfolio risk. Aggressive investors who take on as much as 20% in non-correlated assets can dramatically lower their “drawdown” in a bad market (from 41% for a stocks-only portfolio to only 7.5% for a diversified portfolio), while increasing their overall returns (from 7.4% for that stocks-only portfolio to 8.9% for the diversified portfolio). This holds even though they used parametric distributions to plan such things.

These are important lessons to take away from these troubled times. If you embrace such a strategy, chances are that you'll not only be smiling on down days in the market but you'll also come to actually enjoy the unpredictable markets we now live in, too.

[ Editor's Note : As Money Morning Investment Director Keith Fitz-Gerald demonstrated in this essay, the ongoing financial crisis has changed the investing game forever, making uncertainty the norm and creating a whole set of new rules that will quickly determine who wins and who loses in today's global investing markets. Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as " The Golden Age of Wealth Creation ." His key discovery: Despite the gloom, investors may well be facing the greatest profit opportunity of their lifetimes.

In his newly launched Geiger Index investing service, developed after more than a decade of work, Fitz-Gerald has amassed a winning streak of profitable picks. Check out our latest insights on these new rules, this new market environment , and this new service, the Geiger Index .]

Money Morning/The Money Map Report

©2009 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules