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So, after writing this long series of Newsletters questioning whether the stock market prices shares in an unbiased manner to the point where there are no opportunities for out-performance (at least not on a consistent basis over time and after allowing for risk), where do I stand?
Substantially efficient
While modern, large and sophisticated stock markets exhibit inefficiencies in some areas, particularly at the strong-form level, it is reasonable to conclude that they are substantially efficient and it is rare that a non-insider can outperform the market.
Look for difficult-to-eradicate psychology
One of the more fruitful avenues of future research is likely to concern the influence of psychology on stock market pricing. We have seen in this series how many of the (suggested) semi-strong inefficiencies, from bubbles to underpricing low price earnings ratio shares, have at their base a degree of apparent ‘non-rationality’.
Accept risks others dislike
Another line of enquiry is to question the assumption that all investors respond in a similar manner to the same risk and return factors and that these can be easily identified. Can Capital Asset Pricing Model beta be relied upon to represent all relevant risk? If it cannot, what are the main elements investors want additional compensation for?
What about information costs, marketability limits, taxes and the degree of covariability with human capital returns for the investor (e.g. earnings from employment)?
These are factors disliked by shareholders and so conceivably a share with many of these attributes will have to offer a high return.
For some investors who are less sensitive to these elements the share which gives this high return may be a bargain.
A problem for the researcher in this field is that abnormal returns are calculated after allowance for risk. If the model used employs a risk factor which is not fully representative of all the risk and other attributes disliked by investors then efficiency or inefficiency cannot be discerned.
One way of ‘outperforming’ the market might be to select shares the attributes of which you dislike less than the other investors do, because they are likely to be underpriced for you – given your particular circumstances.
Be lucky
Another way to out-perform is through luck – which is often confused with the possession of superior analytical skills.
Getting a good set of rules
Another method is through the discovery of a trading rule(s) which works. But if it becomes widespread knowledge it may stop working, unless it is based on some deep-seated psychological/cognitive error prevalent among investors.
On the other hand, you could ….
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