Wednesday, July 19, 2017

Efficiently Inefficient #1 : How to think about market efficiency.

I am writing this article in Raffles City Food Court after a second day of lectures for the Part B Bar preparation exams. Two uncles sitting next to me are talking to each other about MLM and bragging about their recent trading successes via cryptocurrency trades. The conversation is quite fascinating but I have a blog article to write.

The book Efficiently Inefficient by Lasse Heje Pedersen was written as a textbook for folks who want an introduction into various hedge fund strategies. I thought the concepts may be be useful for retail investors who want to craft a more sophisticated investment strategy. After all, you guys are aware that I have since the last book, built a margin account which I intend to expand over the next two weeks. By August this year, about 4% of my total portfolio value would be leveraged by 200%.

We will start with a relatively simple concept of market efficiency.

The idea that markets are efficient is the idea that our stockmarket reflects all market information. Market prices always reflect fundamental value and readjust when breaking news occur. If markets are efficient, then active investing is pointless and your should just minimise your costs and just buy ETFs for your portfolio.

The converse of market efficiency is that the market prices do not reflect fundamental value and it is possible for active investors to succeed. Human beings make mistakes and it is possible for the investing crowd to become overexuberant or overly pessimistic.

The idea of markets being efficiently inefficient is a new one which tries to be a halfway house between market efficiency and market inefficiently. Markets are inefficient enough just to compensate money managers for their costs and fees but efficient enough to make it hard for a new market manager to enter the market.

If you adopt this belief, then market managers will typically perform well enough to be rewarded for the liquidity they provide to the markets but will find it challenging to perform beyond what they charge an investor in terms of trading costs and management expenses.

Some active managers will be able to exploit market anomalies over the short term but they will need to keep searching for new ideas to remain relevant to their clients.

I would this hypothesis to be correct. The only way to keep ahead of the markets is to keep reading and finding new ways to invest your money.

It does not make sense for anyone to be permanently financially independent without performing a porfolio review every now and then readjusting their investments to adapting to changing circumstances.

1 comment:

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