Exploiting Efficiency

The ‘efficient market hypothesis’ (EMH) is a theory that states it is not possible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

People don’t like to believe in the ‘efficient market hypothesis’ because it tells them you can’t really get much more from stocks than you can get from a US ‘T-Bill’, which right now is basically nothing. People do not trade or invest with the aim of receiving 5% or 6% annual returns; they do it to get rich. When I tell traders I make about 25% a year through investing, I receive nothing but scorn.

Yet 10% to 20% yearly profit is great. 25% is a truly wonderful return. It is approximately the yearly profit that turned Warren Buffett into the richest man in the world. Few people dicing with the markets understand that a 25% return is more than enough to reach financial nirvana over just a few years. But let’s forget this point for now. Let’s flip on to the ‘efficient market hypothesis’ and why you should get really familiar with it.

Essentially, conducting an efficient market breakdown is where you will find opportunity. Of course nothing can ever be perfect. No law is completely inescapable. The odd person has fallen 20,000ft out of a plane and survived. And ‘efficient market hypothesis’ is certainly not stronger than gravity. It does bend and break. Once you understand this, you can start thinking about making fat profits.

If you trade away blithely thinking that the ‘efficient market hypothesis’ can be beaten with some fancy moving averages you will lose all your money. The ‘efficient market hypothesis’ has an army of people crunching the data trying to extract profits and have already traded away all numerical skews (advantages) long ago.

All the opportunities expressed in this data that logic can pick up are long gone. It’s a 50/50 game minus costs, which is the equation that is the basis for your losses and the broker’s pay packet.

Looking Elsewhere

So instead, you need to think about areas of the market which the investment and trading armies are not, thereby picking up on scraps of inefficiencies lying around. Small caps, for example. Only crazy private investors are in that section of the market. Funnily enough, historically that’s where the fat profits are – where the big operators can’t be bothered to play. I’m not saying invest in small caps, I’m saying small caps are an example of a less than perfectly efficient market. It’s one where you can get an edge.

Let’s move on from investing, however, because very few people care about making good money slowly, they want to spin the trading wheel. We can, of course, speculate. We can postulate on all sorts of matters, but let’s face it – we know ‘Jack’! We aren’t the next phone call the bureaucrat is going to make; that’s to an investment bank.

You and I are at the back of the queue when it comes to learning what’s going on. We are just guessing and you know where that gets you, on a bus to the poor house. Instead, let’s think about events when the market isn’t that efficient. How about at the moment when options are expiring?

Is there two days to go until quarter end and 30 minutes remaining? Are all those block order algoriths wondering how they can complete the fag ends of their orders by close? You don’t have to be Nostradamus to see them panicking up to the wire or to sit there taking the other side of the trade.

Embracing the ‘efficient market hypothesis’ will set you free; it lets you be part of the play, an actual unit of the process working in the inevitable direction towards the logic of a perfect market. Don’t fight efficient market hypothesis be at one with it.

Clem Chambers, is chief executive officer of ADVFN and author of several bestselling investment and trading guides