Saturday, May 17, 2008

Inefficient Markets

Stock market experts have argued for the past four decades about whether the stock market is efficient or not. Those who argued for efficiency were basically saying that future performance of stocks was essentially random, because as soon as some mispricing or inefficiency offered a profit opportunity, someone, somewhere would take advantage of it, and in the process eliminate the opportunity for others. Those who argued against it pointed to the performance records of some of the world's greatest investors, compiled over many years, and how unlikely that level of performance would be if it was truly impossible to have an edge. More recently, both camps have generally adopted the more moderate (and correct) opinion that the stock is very (but not completely) efficient. Opportunities for outperforming the market as a whole do exist, but they're VERY hard to find, because you essentially need to be the only one to identify them to profit from them, and the patterns that work now will be discovered and eliminated, requiring constant adjustments to strategy.

Whenever I'm evaluating an opportunity for speculation (and I'd include both investing and handicapping in this category), I think about whether I'm operating in an efficient 'market', and what that means for me.

In my opinion, the reason the stock market is so efficient (and tough to 'beat') is that there are an unlimited number of participants (so there's a greater chance that somebody is going to find each profit opportunity) and participants can 'bet' as much as they want (so just one or two people finding an inefficiency can completely eliminate it).

The same situation exists with parimutuel betting. Anyone can participate (even more true with the advent of online betting), and they can bet as much as they want. This means that (like the stock market) you really need to be one of the very best handicappers to come out ahead. That's particularly true when you add in the fact that handicapping (unlike the stock market generally) is a negative sum game...overall the payouts are less than the total amount invested.

Ownership of horses does not necessarily operating as efficiently. While in theory, anybody can participate, not everyone does. At an auction, or when evaluating a horse to claim, you may really only be competing against a few hundred other people. If you're operating at the high end of the market, the number may be even lower. How many people really are involved in the bidding for Big Brown's stud future right now? 2? 3? Maybe 4? Only one of those has to overvalue him for IEAH to hit the jackpot. The less efficient a market is, the more important it is to know who you're competing against, and the more profit opportunities you'll find if you're good, but not the best at something. As an owner, you should be looking for opportunities like those found at a poker table or in a fantasy baseball league, where you're competing against the same 8 or 9 people over and over, and if you're the best, you're generally going to come out ahead in the long run.

This might mean playing the claiming game at a smaller track with less claiming stables, it might mean hording a top stallion's offspring because you know there's a buyer willing to consistenly overpay for them, or it might mean privately purchasing horses so that you're in situations where you're competing one on one with an unsophisticated seller.

1 comment:

Alisa said...

Interesting comment! I have just started my journey into the stock market and I am almost overwhelmed about the amount of information available. As I am still formualting the type of investor I want to be I have been leaning towards value investing and the importance of investing in a business based on it's intrinsic value. With that said, I am wondering to what extent does it matter what the market is doing; except maybe to identify profitable entry and exit points.