How To Profit From An Inefficient Market

By Gregg S. Fisher | February 09, 2010 AAA
How To Profit From An Inefficient Market

Markets are efficient. People are not. There is a profit to be had in the disconnect between the two.

For the better part of the last 30 years, conventional investment wisdom has been governed by the so-called efficient markets hypothesis. It states that the broad stock market cannot be beaten on a consistent basis because all available information is built into stock prices. (For background reading, see Working Through The Efficient Market Hypothesis.)

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Following the logic of efficient markets, the best way to invest in U.S. stocks is the passively managed index approach. That means owning mutual funds that closely track the S&P 500 index, or the total market index like the Vanguard Total Stock Market Index Fund (VTSMX) and Schwab S&P 500 Index Fund (SWPPX), or exchange traded funds like the U.S. SPDR S&P 500 ETF Trust (SPY) and the Russell 1000 Index Fund (IWB).

On paper, this makes a lot of sense. After all, prices already represent the best collective estimate of value among all the players active in the market. Logical, right?

Not so fast. The theory ignores one crucial element: human emotion. It is humans that drive investment decisions, and we humans are not ourselves always driven by logic.

In fact, we humans are so consistently illogical that our illogic itself is very predictable. For attentive investors, that's good news. By studying other investors' recurring patterns of irrational behavior, it is possible to build an investment strategy that profits from the inherent lack of efficiency in markets that are driven by humans.

The heart of this approach to investing is momentum, or the tendency of winners to keep winning and losers to keep losing relative to their peers. This results because people tend to take great pleasure in holding onto their winners perhaps longer then they should. Also because investors tend to hang onto their losers a little longer then they should as well, because they don't want to lock in losses by selling. Just like Newton's first law of motion, which posits that objects in motion will stay in motion, stocks on a winning streak often tend to stay on a winning streak until they reach highs well above their fundamental values. Likewise, stocks on losing streaks tend to sink lower than an unemotional assessment of their inherent values would indicate they should.

This behavioral phenomenon is the result of the representative heuristic, or the "law of small numbers." Based on a limited perspective, investors mistakenly conclude that companies realizing extraordinary earnings growth today will continue to experience extraordinary earnings growth in the future. That certainly would seem to explain at least in part the upward momentum behind stocks like Google (Nasdaq:GOOG) and Amazon.com (Nasdaq:AMZN).

By applying this backward-looking perspective to forward-looking expectations, investors tend to overestimate positive signals and push prices of winners beyond their intrinsic values. The same pathology takes over when a company is showing negative earnings growth.

In fact, this pattern occurs so frequently that research by Narasimhan Jegadeesh and Sheridan Titman found that by applying an investment strategy to the momentum phenomenon, investors could earn returns of about 1% per month, which is a significant premium to the standard market results. This analysis has been found in over 40 markets globally and not just the U.S.

According to Gerstein Fisher's own research, in 45% to 50% of all U.S. actively managed growth funds that actually manage to beat the market, it is a tilt toward owning momentum stocks, as well as smaller companies and value stocks over the market weights, that accounts for most or all of returns in excess of the market's.

To isolate the impact of the momentum derived from behavioral factors, value and market caps on real-world market performance, Gerstein Fisher applied a factor-based regression analysis to almost 750 actively managed growth funds between October 1999 and September 2009. The analysis allowed us to isolate the individual variables that contributed to fund manager outperformance.

According to our findings, 82% of large-cap growth fund managers and 75% of small-cap growth fund managers outperformed their relevant market benchmarks over the decade studied. However, if you strip away the out-performance that resulted from above-average exposure to the risk factors studied (largely momentum), only 39% of large-cap growth managers and 36% of small-cap growth managers outperformed the benchmark.

Put simply, much of what appears to be fund manager "skill" is merely high exposure to momentum and other risk factors.

How can investors profit from this phenomenon? Perhaps the most important consideration when looking to take advantage of momentum investing is to access it as part of a more comprehensive, structured investment strategy. History shows that over the long term investors tend to be compensated with returns in excess of the market's average in exchange for assuming certain types of excess risk. Richly priced momentum stocks, which run the risk of tumbling back toward their long-term earnings multiples, are one such example.

Other types of stocks that likewise tend to compensate investors well over time are small caps and value stocks, which tend to be characterized by both higher volatility and higher long-term returns than the market as a whole. The best approach is for investors to seek exposure to all these risk factors. Investors who diversify their holdings broadly, while tilting toward these risk factors, can improve their chances of earning reliable returns over time.

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