100 Ways to Beat the Market: #30: Respect the efficiency of markets.

Value investing is seemingly more popular than ever. Books on value investing continue to multiply. Several universities offer programs based on the principles of value investing, and a number of MBA programs send their students on pilgrimages to Omaha to meet with Warren Buffett. These schools produce many trained specialists who find work in various value-oriented hedge funds and money management firms. The web is full of various sites and blogs – like this one – that follow a value investing philosophy.

It is impossible to assess the collective fruit of all these efforts. It is, unfortunately, very possible to be well versed in value-investing methodologies and still fail to produce above-average results.

One thing that can lead to sub-optimal results is under appreciating how efficient the market is most of the time. Wall Street is full of a lot of smart people who dedicate tremendous energy to following the market. The Internet has only made it easier to stay on top of the latest news and information. It is wise to recognize this reality and remain very humble about being able to gain an edge on the basis of better research alone.

In spite of these highly transparent markets and trained professionals, the short comings of human nature are still occasionally on full display, in the form of multitudinous frailties, overreactions and misjudgments. You absolutely want to look for these periodic occasions when the person on the other side of the trade is acting in a way that is irrational.

This is precisely why the Mr. Market parable is so central to value investing. As Bruce Greenwald put it in an interview with The Motley Fool, “Graham saw was that the best indicator of irrationality – sort of a systematic, statistical indicator of irrationality on the other side – is when things get oversold.”

Exploiting this is not so much about having an information edge over the other guy – although you must thoroughly do your homework – as much as it is having an edge in temperament. That is why your search strategy should focus on spotting situations where securities are clearly oversold and sellers are acting irrationally.

Most of the time these are unavailable, but, when they are, you must pounce. These are where the big money is made and where the true, professional value investors, who consistently beat the market, operate.


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