As Rodney says well above, the markets would be brutally booooooring if investors were actually the “rational actors” market theories have assumed they are for many years.
The truth is profitable investing opportunities arise from the irrational behavior of investors. That – the opportunity to capitalize on market inefficiencies – is the good news.
The bad news is it’s not so easy to “beat the market.” It’s entirely possible though.
Investors that want to come out ahead over the long run need an edge… a unique competitive advantage that turns the odds in their favor… that allows them to outperform the market over the long run.
The Efficient Market Hypothesis, of course, claims there is no such thing as “an edge.” This theory suggests there is simply no way to beat the market. You’ve no doubt heard sayings like, “everything is always priced in” and “there’s no such thing as a free lunch.” That’s this hypothesis in a nut shell.
And I think the Efficient Market Hypothesis is bunk.
I can point to many examples of traders and money managers who do consistently beat the market.
The problem with the Efficient Market Hypothesis is that it overemphasizes the millions of investors who trade without a plan… who place bets on mere hunches… who have no quantifiable edge.
To me, saying it’s impossible to “beat the market” is like saying “everybody loses in Vegas.”
While that may be true for most, it’s not true for everyone.
Think about card counters, for example. A number of smart, disciplined card players have made a fortune in Vegas by “counting cards” at the Blackjack table. The casinos hate this of course, because it flips the odds, which usually favor the house.
The ability to count cards, instead of merely playing Blackjack on hunches and gut feel, is the edge that allows a small group of card players to make money consistently at the casino.
The same theory applies to trading and investing.
An investor’s edge could be his knack for reading between the lines of annual reports. Or, it could be a unique price pattern that accurately predicts market tops or bottoms.
My edge is relative strength.
Through countless hours of research, I’ve found a unique way of picking up on shifts in momentum. This helps me stay invested in sectors and stocks that are outperforming the broad market.
Here’s an example…
The Financial Sector (XLF) spent most of 2011 underperforming the broad market. So I avoided making any new investments in this sector during that time.
But 2012 was a whole different story. I first picked up on XLF’s gaining momentum in early December 2011. By December 22, my relative strength analysis showed financials were beating the S&P500 by a wide enough margin to warrant an investment.
Sure enough, this sector continued to beat the market during the first three months of 2012. While SPY was up 12%, XLF nearly doubled that with a gain of 21% by the end of March. By this time, the financial sector’s outperformance was waning.
I’ve found these trends usually only last, in a predictable way, for up to three months… so when the sector began to cool it was time to get out and move on to another, hotter investment.
Trends like this allow investors to make money. The market would move differently if it were in fact as efficient as an outdated theory has suggested for years. And, there’d be no money to be made.
My advice? Forget the Efficient Market Hypothesis… with an edge like this it is entirely possible to beat the house.
If you haven’t done so already read the Survive & Prosper issue on “Why There is Always Boom and Bust.”