After decades of grueling battle between the idealists and the realists, the realists have prevailed; no longer is it widely accepted that markets are inefficient — the accepted wisdom is now inefficiency.
For a long time markets were thought to be efficient and the brave few who proved this wrong — like Warren Buffett — would have to argue their case for many years before being listened to. And as the likes of Warren Buffett have shown, it would have been a mistake to believe the accepted wisdom of market efficiency.
The wisdom has changed now — markets are not efficient — but that still doesn’t mean we’re right to blindly accept it.
How often do you ask yourself why, or where, markets are inefficient? How do bargains arise and why do you know about them before others? What are thousands of investors missing that you aren’t? Have you asked these questions or have you presumed you know the answers?
Automatically believing any accepted wisdom is a mistake, even the idea that markets are inefficient. Believing anything without an understanding of what you believe is foolish. If you blindly believe in inefficient markets you’ll fall victim to the same mistakes as the efficient market-eers. Inefficiency is a broad term which applies in specific contexts, blindly believing in it is much like being told it’s going to rain at some point this evening and thinking the entire world is going to receive rain this evening.
This two-part series is going to give you the context in which inefficiency reveals itself. You’ll learn everything you need to know in understanding market inefficiency; why, how, where, when, and so forth. This won’t transform you into a young Warren Buffett, but it will prevent you from making a whole lot of big mistakes, which is worth a whole lot.
But first, why does this matter?
As previously touched on, markets are not uniformly inefficient. They are inefficient in specific places, for specific reasons, and at specific times. The investor who doesn’t understand this distinction wanders into games they’re unequipped to win.
Consider the investor who buys a large, liquid, heavily followed stock convinced they’ve spotted something the market has missed. They’ve entered a fiercely competitive arena and bet they know something that thousands of smart professionals don’t. They’re competing against informed investors, they have no edge. The typical outcome is to hold onto a dud for far too long because they stubbornly hold onto the idea that they know something the market doesn’t. It’s far more likely the market knows something they don’t.
This is why it’s key to understand the landscape of inefficiency. Once we know why a mispricing exists, we can exploit it; institutional size constraints, ESG mandates, complexity aversion, forced selling and so on, these are not anomalies, they’re structural and repeatable.
The market is a brutal and unforgiving place, it’s no use in hoping to get lucky in a fair game when you can make the game unfair. I believe understanding and exploiting structural inefficiencies is the only way to make the game unfair. To do this we have to know how, where, and why the inefficiencies arise. That’s what this two-part series is for.
Back in January, one of my favourite financial authors — Michael Mauboussin — released a fantastic paper called “Who Is On the Other Side?” It’s a guide to understanding market inefficiency. You can read it here, but if you don’t have the time to read all 51 pages, I’ll be taking us through the important parts, alongside insights from other talented investors like Howard Marks.
The contents of today’s article are as follows:
Etorre’s Wisdom
The Types of Inefficiency
Behavioural Inefficiency
Analytical Inefficiency
There’s a lot of information coming up so this is going to be a two parter; the second part will be released next week where we discuss:
Informational Inefficiency
Technical Inefficiency
Dare To Be Great
Let’s begin!
Firstly, as investors we ought to believe in both inefficient markets and efficient markets. For anyone to make dependable profit, markets must make mistakes and eventually come to realise its mistake. We rely on it to be an imperfect system that eventually corrects its imperfections.
The market corrects itself in a few ways, two of them being:
The wisdom of crowds (only under certain conditions…), and
the presence of some rational investors who bring price closer to value.
The wisdom of crowds is a heavily debated topic as it can be relied on to both rationalise and irrationalise prices; the crowd is both brilliant and delusional, which is why — as Mauboussin states — the wisdom of crowds only works under the following conditions: a system requires “a diversity of views, a mechanism to aggregate those views, and proper incentives”1 in order to price assets efficiently.
If these criteria are broken, price setting becomes irrational. In any bubble you’ll see the diversity of views break down; think about attitudes towards tech in the late 90’s, real estate in the early to mid 2000’s, or quality companies in the 60’s. The common denominator among them all is a consensus belief, no one challenged each other and everyone had the same views. A consensus belief will always occur when the diversity of thought is broken, and that’s when you’ll see some of the craziest prices — both high and low. The most dependable red flag for any investment is when everyone agrees on it. Diversity is critical.
Regardless of its occasional flaws, the market tries its best to be efficient — and it’s pretty damn good at it. If there’s an excess return available, investors will chase it until it’s no longer available. The market is a system that seeks to eliminate excess returns, in fact the existence of a high return is the very thing that prevents it from continuing. To better explain that statement I’m going to turn to Howard Marks, one of the most brilliant investors of our time. In his 2002 memo, “Etorre’s Wisdom”2, he explains how both high and low returns will always be destined for regression.
There are few ideas as consistently frustrating as Etorre’s Observation. Put simply, Etorre’s Observation is that ‘the other line always move faster.’
Whilst driving in 2002, Howard Marks’ son asked a simple question: “Dad, why do you always have to drive in the slow lane? Why don’t you switch to that one; it’s moving faster?” Howard’s answer to this question ended up forming the basis of one his most brilliant — and underappreciated — memos.
He analogised markets and investor behaviour into a crowded highway.
When driving on a crowded highway, we’re often frustrated by how fast the cars in the adjacent lane seem to travel. We move over, only for that lane to slow down and the one we left to speed up. Sometimes someone tries to weave their way through each lane, but it never really amounts to much, you often smugly meet them at the next traffic light; the net result is often zero, they just take on more risk by driving recklessly in the process.
This is the function of any efficient system: it works to reduce outperformance. Everyone sees the fast lane, they switch to it, and that makes it the slow lane. It is the behaviour of the collective that alters the environment.
To make good time on the road in spite of the efficiency, you have to find the inefficient roads; the roads others won’t travel; the route with hazards that others are scared of, once you’ve made sure you can drive around them of course; the lesser known back-roads; the industrial park that feels like a dead end; the roads with ugly scenery people don’t want to see; it is their lack of popularity that makes them fast and that is precisely why they offer high prospective returns.
This is why it’s important to know the roads and to know your fellow drivers.
Who is overtaking you?
Who are you taking road space from and why are they giving it up?
What kind of drivers are in your lane?
How can you find roads that are off the beaten path?
How can you drive better than others?
Is there a shortcut that they don’t know about?
Is there a road only you are equipped to drive?
Is this road crowded by drivers better than you?
Can you find somewhere that you’re the best driver?
These are the kind of questions that lead to a deep understanding of how to actually make better time on a crowded highway — without relying on luck. It’s the same with markets, of course. When we understand the where, why, and how, markets come to be inefficient we’re far better equipped to navigate it with intention. Not luck.
It’s critical to every investor and I believe it to still be an overlooked topic.
Leaving highways and coming back to markets, let’s explore how and where we can uncover dependable inefficiency, with the help of Mauboussin and co.
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