The Key to Making Money in Shares
You make the most money when everyone else is wrong.
This is a really important piece of the jigsaw puzzle for you as an investor. You need to take this on board. Get through the first part to get to the 'Inefficient Market Hypothesis'.
You may have heard of ‘EMH’, the ‘efficient market hypothesis’. Anyone who’s read the introduction to any textbook on financial theory can tell you all about it.
EMH basically says that you can’t beat average returns because the markets are, at all times, "informationally efficient". That is to say, all prices reflect all available information at all times. One form of EMH, the 'strong EMH', suggests that this efficiency of information extends beyond publicly known information to
all information (including insider information), which it has to be said, in some of those small stocks in Australia, is probably not far off the mark.
The theory has been rubbished as theory, and there are many very plausible reasons why it should be, but none as obvious as the fact that if were it true, the whole financial advisory industry would be out of a job because no one would be able to add value.
If all known information was instantly reflected in all share prices, the only way brokers, fund managers, analysts and taxi drivers could possibly add value would be by knowing the unknown, which is impossible. So, the only way we could add value would be to guess, and it follows that if all anyone could ever do is guess, then all investment outcomes and fund performances would simply reflect the normal distribution curve of a random outcome, and brokers, fund managers, research analysts would hold no advantage over Joe Bloggs in front of his CommSec screen.
The Normal Distribution of Random Returns
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So if the efficient market hypothesis were really in effect, and all fund managers and investors were guessing the future instead of knowing, then all of them would be part of the bell curve of random returns, and the successful ones, while marketing themselves, their investment philosophy, and their brilliance, would simply be marketing their luck, because there would be no good or bad fund managers, just some lucky ones.
The industry would also die, because luck is not something anyone would pay for.
Of course, we don’t want to get too carried away with theory. After all, you can pretty much guarantee that anyone who took the time to write an academic paper about the stock market being guesswork wasn’t a fund manager, didn't know for sure, and was more interested in academia than real life.
But the theory does raise the interesting question of whether there isn’t some significant truth here.
Marcus Today contains stock market education, commentary and actionable ideas.
The Inefficient Market Hypothesis
Thankfully I have another theory, one that goes to the core of making money in the stock market but is rarely voiced, until now. It is this. The
Inefficient Market Hypothesis.
The Inefficient Market Hypothesis is based on one indisputable fact:
"The most money will be made in the stocks that the analysts get the most wrong."
Think about it. Every year, the top and bottom-performing stocks are not the stocks the market predicts most accurately; those stocks will hardly move. The big money is always made in the stocks that the market got most wrong. The prices that move the most are in the stocks that surprise the most.
In other words, you will not make money knowing what everyone knows. You will not make money listening to an adviser telling you about consensus forecasts, PEs and yields, or calculating valuations based on accurate forecasts. You will not make money looking at Bloomberg or Reuters numbers, or our
All Ords Spreadsheet and
Stock Box. All that information, all those numbers, are in the price. All that data is valueless because it is known. It is the consensus, it is the basis of the current price.
The only thing that will make you money is knowing what is not in the price, and that means working out what assumptions the market has got wrong, not right.
In my Inefficient Market Hypothesis, there is more money in analytical failure than victory, and the most fertile ground for making money is in working out what is wrong with the consensus, what assumptions are wrong, and what big drivers are going to change in a way that no one expects.
To do that, you need an open mind, objectivity, and imagination. This is where
you must watch the herd, not join the herd (another core Marcus Today tenet). Having an open mind and being objective about the stampeding herd is where the money is. It is also when prices are at their 'best', at the top and the bottom.
So with any stock (or the market), start out by asking yourself "What is the market assuming?".
Then ask, what have they got wrong? What is everyone assuming in current share prices? Then question it. It's a much more profitable use of your precious investment attention than simply agreeing.
We are making mistakes somewhere. Some of those prices right in front of you are based on incorrect assumptions. You just need to work out, guess, or know which assumptions they are, because there is a fortune in knowing what everyone else is getting wrong.
More about the author – Marcus Padley
is a highly-recognised stockbroker and business media personality. He founded the
Marcus Today Stock Market Newsletter in 1998. Over the years, the business has built a community of like-minded investors who want to survive and thrive in the stock market. This is achieved through a combination of daily stock market education, ideas and activities.
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