Why you can beat the market over time
Last week, Professor Eugene Fama co-won the Nobel Prize for economics for his Efficient Market Hypothesis (EMH). This theory shows that the market is efficient and digests all information practically instantaneously. And it shows that it is virtually impossible to beat the market over time. But investing greats like Warren Buffett have proved that there is money to be made. Read on to find out why you can beat the market over time...
The first step is to realise that markets are not always efficient, Robert Hsu in Money Morning US
This goes against the Efficient Market Hypothesis (EMH)
One of the most obvious market inefficiencies is the fact that investors do not always behave rationally. This is especially true when the extremes of fear or greed dominate the market milieu.
For example, during times of panic dominated by fear, investors often engage in irrational selling.
This is precisely what happened during Black Monday - the market crash of October 19, 1987. In the US stocks sold off 23% without any meaningful change in market fundamentals.
Conversely, when greed dominates markets, investors often engage in irrational buying.
In 2000, during the height of the tech bubble, 3Com Corp. spun off its wholly owned Personal Digital Assistant division, Palm, via an initial public offering (IPO). Palm only accounted for 15% of 3Com's earnings at the time.
But, by the close of trading on its IPO date, Palm was worth nearly twice as much as 3Com - which still owned 95% of Palm - simply because Palm was in the white-hot telcotech sector.
The market isn't efficient when fear and greed are in the driving seat
These examples of irrational behaviour are just two of many such decisions driven by extreme fear and extreme greed.
When the emotional pendulum swings toward either end of the fear and greed spectrum, when investors behave irrationally, is precisely when markets are inefficient.
The way to make money during these extreme times is to avoid getting caught up by the prevailing emotion, to act rationally, and go straight in the opposite direction.
So there you have it, why you can beat the market over time.