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How to Beat the Efficient Market

Discussion in 'Medium/Long Term Investing' started by RickyY, Sep 17, 2019.

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  1. RickyY

    RickyY

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    The stock market is like a pari-mutuel system of horse racing. Everybody goes there to make a bet and the odds change based on what’s being bet. Everyone can tell a quality company has better profitability, higher return on capital than a company with a terrible record. But when you look at the odds, the terrible record company has a 7 P/E and the quality company selling at 25 P/E, it becomes hard to determine which one is cheap. The odds make it hard to beat the market. The market is efficiently priced to a point.

    If you follow the market or have a consensus view, you only earn a market average return for being right. But that’s not the outcome you want as a stock picker. It is better to invest in index funds or passive ETF if achieving market returns is the financial goal. What you’re after is outperformance—above-average market returns. To do that, you’ve to be a contrarian.

    [​IMG]
    Contrarian means having a different view of the market. It doesn’t have to be the opposite; you don’t have to think the market has to go down. If the market is going up yet you think it is going to move in the other 99 directions, that makes you a contrarian. The essence of a contrarian is to think differently.

    So how does one think differently to achieve long-term outperformance? There’s no universal formula. If there’s one, the consensus would adopt it until the odds ensure an average return over time. But here is something to think about. To beat the market, pay attention to the input. This can be expressed in an equation.

    Input = Output ​

    Process -> Results​

    Output, the results, is determined by what goes into the input. To change the output—from an average return to outperformance—you have to change the input. That is, what goes into the investment process.

    Take stock screening tool as an example of input. Screeners are popular because it saves time. It’s efficient. But here’s the problem. Do you know anyone who doesn’t use a screening tool? Not many. Google stock screening, and there are 161 million results. Anyone armed with a screening tool sees what you see. What metrics do you use to screen stocks? Low P/E? High ROE? Price-to-FCF? Magic formula? Ben Graham Net-Net? The bad news is that hundreds of thousands of investors have culled through those criteria so many times that whatever is left are unlikely to be bargain anymore. Efficiency is a disadvantage when everyone wants to be efficient.

    This concept applies to more than the screening tool. If your input is the same as everyone else, your output is not going to be that different from the rest. If you follow the market, read the same mainstream news, think in a similar fashion and use the same process as everyone else, it is hard to outperform in the long-term.

    Imagine buying a house. You determine your budget (the price), the location, number of rooms, and so on down the priority list. But everyone else is using the same criteria to buy a house. Which means you’re competing against the majority in a competitive market to look for value. How do you find value if you are looking at the same place as everybody is?

    What if instead of an efficient tool like a screener, you do something inefficient? Like, go through every company starting from alphabet A to Z? That’s time-consuming. Who does that? That’s the point. No one is doing it. And that’s where the potential outperformance comes from. There is no guarantee your time will be worthwhile. But there’s a higher chance of outperformance from an unconventional method than a conventional method like a screener. What about instead of using those popular metrics, you look for companies as measured by durability? Strong capital allocation skills? Companies that promote failure? Companies that have the highest employee satisfaction? That’s hard because there’s no way to quantify these things. What about companies that no one would touch with a ten-foot pole? Again, it’s hard for psychological reasons. Not many people do it. But that’s how you beat the market. Outperformance comes from doing what others aren’t willing to do.

    If you ever look at the stocks owned by some famous investors, you’ll notice none of their portfolios look alike. Some have concentrated positions, others have a diverse portfolio; some hunt for special situations, deep value while others focused on franchise business or small caps. However, what’s interesting is not how different their portfolios are. Rather, it is the similarity that they all managed to beat the market over the long-term. These investors build their edge through originality—unconventional ways to find ideas and an investment process that can’t be easily replicated. They’re all contrarian in their own way.

    Being original free you from all kinds of rules. You have the freedom to develop your own rules as long as they’re grounded on sound principles. How do you develop original ideas? For one, learn what surprises you. Read widely—most of what makes you a better investor lies outside of investing books. Cultivate second-level thinking. The more you read and think, the more ideas you gather. And the more ideas you have, the higher chance of connecting them in creative ways. Originality starts with making connections. Occasionally, some of these connections will turn into valuable insights that lead to outperformance.

    In William Thorndike’s The Outsiders, he profiled eight unconventional CEOs on how they generated an extraordinary return by doing things that confound Wall Street. While the book is written more for CEOs and hedge fund managers than individual investors, it hits home an important message: To achieve exceptional performance, you have to play your own game, not rules of the game set by others. What’s more, he discovered that while these CEOs all have their own unique, different approaches to their businesses, they all share a common trait—they’re independent thinkers.
     
  2. qldfrog

    qldfrog

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    Interesting approach
    But obviously, darwin selection like, some approaches are not duplicated as they just fail and all previous independent thinkers who tried these just failed, and you will never hear about them...
    A train of loosers for one Rockefeller
    Personally very independent thinker, ahead of many trends, but professionally wise, only a few of my unusual approaches were successful, but it is true one of these bought my house and allow me to retire now in my early 50s..
     
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  3. RickyY

    RickyY

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    You're not wrong. There are elements of silent evidence/survivorship bias that can be hard to tell.

    Independent thinking yet right. And the majority is right most of the time.

    And I think we need to study both successes and failures to have a balanced view. Study failures to avoid survivorship bias, and often what not to do is more valuable than what to do. On the other side, studying failures isn't as straightforward, there are countless ways to fail, but only a few pathways to success, hence studying success is still required.
     
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  4. willoneau

    willoneau

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    If we make profits from getting on a trend early and riding it until the end, how can you be contrarian if the crowd creates that trend.?
     
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  5. systematic

    systematic

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    You've answered it already. You got on early and you didn't hold on (too long) at the end.

    Contrarianism isn't about wanting the stock to go in a different direction. It doesn't matter what 'style' of trader you are. Call yourself swing, pattern, value, quant, trend following, net-net, fundamentalist or whatever you want (phew!). Anyone going long today wants the stock to go up tomorrow!

    So, back to your question, 'how can you be contrarian if the crowd creates that trend?'

    I answer that for myself by saying, 'I am being contrarian, behaviourally.'
    That is, I go against the *crowd's behaviour in a trend.

    You and I get into a trend. It might be underway already (perhaps people far smarter than us began it). But at least we're in.

    The 'crowd' however, exhibits all kinds of crazy behaviour. Some examples:

    They get worried at high prices (we all know the charts where something that looked high 3 years ago because it was up 100% in a year, creating new highs...and then we fast forward the chart to today and see that it became a ten-bagger). So, they wait for price to retreat. Sometimes the stock then gets away from them without retreating (or retreats, but not enough for them) and now they're bummed because they've missed out again!

    Studies will also show that they (the 'crowd') will sell winners early. Maybe they manage to hop on. Price retreated a little bit and they caught the dip. Now price is off again and they're up 20%. Nice profit in 3 months! They're out, on a new 52 week high. Nice trade! 9 months later they're bummed again because price has doubled ('if only I'd held on')

    But some will also pile on right when things are getting toward the end, creating parabolic or bubble (is that called FOMO these days? I seem to have to google so many internet acronyms these days!).

    Now, things change and down it starts to go. Uncertainly at first. You and I hop off at some point (taking a loss from the high, but in profit overall). As above, perhaps some smarter ones were out before us - at the top. But the crowd behaviour continues. We know from enough studies - the crowd will hold on to losers for too long. Buyers at higher prices are hoping for the price to come back. Still, it goes down. Maybe some who bought earlier get out at break-even. Some hold at a loss, hoping for a comeback. Those who bought at the high, sitting on a massive loss, quietly put the stock in the bottom draw, along with the others.

    So - short version is that (for how I see it, anyway) - it's behavioural contrarianism.

    Sorry for getting into a story on that...it's just that you touched on a subject I really got into for a while, as I needed to philosophically come to terms/peace with it before I could adjust my (then) trading plan - a good few years ago now.


    * Of course, you and I are humans too - subject to the same pitfalls and temptations. The contrarian (in my book) is simply the one who knows this, and the challenge they take on...is themselves.
     
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  6. Klogg

    Klogg

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    Stating the obvious, but you could just fish in less efficient waters.

     
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  7. Zaxon

    Zaxon The voice of reason

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    I agree with you. There are certain times when you don't need to be contrarian at all to make lots of money - long bull market runs. It really depends on which phase the market's in. Blanket statements like "you must always been a contrarian to make money" and "if you are making money, I'm going to label your actions as contrarian anyway" I find not to be helpful, notwithstanding there are plenty of times when taking a contrarian view is useful.
     
  8. Gringotts Bank

    Gringotts Bank

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    Buy low sell high...basically. It's low when the majority are selling because they see no future. It's in the share price.
     
  9. willoneau

    willoneau

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    For me personally, how to beat an efficient market or any market actually is taking control of myself. I have often found myself changing my plan, my method or not following it at all. Once I realized why I did I was able to find ways to control it. Following a method or plan which has positive expectancy will get the success we all want in the long run. If we control ourselves and not the way we trade to get that positive expectancy.
     
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  10. RickyY

    RickyY

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    Sure. But this rest on the condition that you 'know' which phase the market is in. That is a hard thing to know. At least for me. And when A cause B, think about whether B cause A too. If everyone 'agree' that one can make money without being a contrarian in a long bull, suffice to say that consensus view would increase the winning probability of being a contrarian, since the bull market is more likely to end if everyone thinks it isn't going to. And lastly, a long bull market followed by one bear market is considered one market cycle. One might do well in one market cycle without being a contrarian (if he 'know' the market phase), but you still need to be a contrarian to survive multiple market cycles.
     
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