How “Efficient” Are The Markets?

PC

One common argument against investing in stocks is that the markets are highly efficient and there is no way that you can outperform the market since all knowledge around a company’s stock is already considered in the stock’s price.

The definition of EMH from Investopedia:

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The common financial advisor or CNBC pundit would say that you are better off investing in market index funds that return an average of 7-10% a year instead of trying to pick stocks that will outperform the market.
I say – don’t let these limiting beliefs stop you, the individual investor can absolutely outperform the market!
Let me show you how!

Efficient AF In The Short Term

The market is incredibly efficient in the short term. There are numerous investment banks, hedge funds, and private individuals who are all looking at the latest earnings reports, quarterly projections, and are supported by an army of quants/quantitative systems/risk models.

Most of these investors are using the same algorithms and triggers to determine when to buy, hold, and sell stocks. Most of these institutions buy and sell a stock within a matter of days, weeks, or months simply due to the fact that they think in the short term.

When a trader at an investment bank wants to buy a stock, they do not buy with the perspective of long-term thinking. Instead, traders are looking to get in and out of a position within a couple of months so they can show their management that they have had significant returns in the past year or quarter and deserve a bonus/raise comparable to their performance.

This short-term behavior all revolves around the SEC’s (Security Exchange Commission) mandate that all public companies must publish quarterly earnings reports (financial statements that are released to the public every 3 months). This allows all the banks to realign any projections/models to real financial data when an earnings report is released, which in turn creates a metaphorical “reset” button on the stock’s price.

So, every quarter the stock’s price will be as close to the “true” value of the company based on all current data.

This creates a huge disadvantage for any common investor who wants to invest for the short term since all the “big money” moves around so quickly quarter to quarter.

However, hardly ever will a trader be buying a stock with a 5-10 year outlook since most traders are incentivized to be short-term thinkers.

This 5-10 year outlook is where you and I beat the market and these big bank analysts.

Inefficient Over The Long Term

It is very rare for any financial system to try to predict how a stock will perform in the long term – primarily due to the fact that predicting the future is hard. Most financial firms (Bloomberg, CNBC, CNNMoney, Zach’s, etc…) only project the price for the next 12 months.

Just take a look at an example from CNNMoney below for Intel (The Best $35 Investment You Can Make):

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In the above image, you can see that 33 analysts provided some estimates on where Intel Corporation (INTC) will be priced in 12 months. That’s all fine and dandy, but what about the next 24 months? 60 months? 120 months?

I would argue that many of us will be alive longer than 12 months, so why should we invest like these traders that get in and out of positions based on short-term estimates?

Instead of being intimidated by these institutional investors and their fancy statistical models, invest using your own personal experiences, your ability to spot trends, and by exercising a level of patience that the “big money” isn’t able to.

For instance, take a look at E.L.F.

elf

Since their IPO last year, E.L.F. has declined due to the short-term increase in costs compared to overall sales. However, E.L.F. still maintains a %20+ growth rate based on their last quarter’s financial statement. At this rate, E.L.F. will double their revenue in less than 4 years (using the rule of 72). Also, E.L.F. will most likely ride the beauty trend and low-cost trend for the next decade or more. If you can think in terms of 5-year blocks or even longer (thinking decade to decade), then you will have a huge advantage over the market.

The ability to be a long-term thinker and investor is one of the last great advantages a person like you or me has in their wheelhouse.

So, avoid short-term buying and selling of stocks.

Simply put, buy and hold.

Warren-Buffett-Quotes-1

Price Is What You Pay – Value Is What You Get

I think everyone at this point knows ‘The Oracle of Omaha’, the second richest man in the world (or is it third?), value investing guru – Warren Buffet.

However, I bet you don’t know that Warren Buffet actually made the majority of his money in the 2nd half of his life. Need proof? Don’t take my word for it, just take a look at the below graph of Warren’s wealth over his lifetime.

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The point I am trying to get across is that we should all invest for the long-term as that is how you beat the highly efficient (in the short-term) market.

Which brings me to the quote “Price is what you pay. Value is what you get”. When you buy a stock, don’t overpay for stocks that have been inflated in the short-term, buy a stock whose price has been understated by the media and wall street. Whether you overpay, underpay, or pay the “market value” for a stock, the underlying company’s operations and products do not change. A change in a stock’s price is only an indicator of what other people want to pay that stock, it is not truly correlated with the performance of a company.

Buy a stock because you want to obtain the value a company has to offer and hold it for the long-term. A short-term investing mindset is bound to leave you beaten, battered, and bruised.

A long-term mindset, that sees 5-10 years into the future, can provide returns that are unimaginable to most people.

If you don’t believe me, then here is another Buffet quote for you.

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If you want to learn more about stocks, then check out two of my previous articles where I describe different types of stocks and the life cycle of a stock when it “IPO’s”.

Understanding Different Types of Stocks -Growth, Value, Dividend, Penny

The Snapchat Story – More Common Than You Think

And as always, if you found this article helpful, insightful or just slightly enjoyable, then please like, comment, subscribe, follow, and SHARE!

Thanks for reading,

Jack

 

 

DISCLAIMER: This article is meant for general education purposes only. I have not considered your personal risk profile and have expressed my own opinion in this article. I may or may not have vested interest in any of the stocks mentioned above.

 

 

 

 

4 comments

  1. Genuinely speaking, i have always believed in long term value creation than the short-term speculation. I think the true meaning of wisely invested stocks would be a period above 5 year. Nicely written article. I completely agree with you in many respects.

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