How to Profit from Inefficient Financial Markets

By: Money_Morning

Keith Fitz-Gerald writes: One of the single biggest fallacies foisted upon the investing public is the notion of an “efficient market.” Academics love it, which is why the “ efficient-market hypothesis ,” or EMH, as it's known, is taught at all the leading B-schools. The broadest version of this theory holds that securities prices already reflect all known information; EMH proponents believe it's impossible to outperform the markets over time - except by luck.

The reality, however, is that the markets are anything but efficient. In fact, not only are the markets highly inefficient, but - as many investors have learned the hard way - they are frequently completely irrational, as well.

First published in 1965 in The Financial Analysts Journal , the efficient-market hypothesis was the result of a nonsensical doctoral thesis penned by Eugene Fama . He hypothesized that the markets are characterized by multiple participants acting in a rational manner in an effort to profit. Fama believed - as the majority of EMH proponents do - that in an efficient market, competition among the participants leads to a situation where the actual prices of individual securities (stocks, bonds, exchange-traded funds, and the like) already reflect the combined total of all known information.

The bottom line: Stock prices, therefore, reflect reasonable intrinsic values at all times. [One version of the efficient-market hypothesis, the so-called "strong" version, actually holds that securities prices reflect all information - even information known only to company insiders, and to no one else out in the marketplace].

Few people understand that the belief in market efficiency - as much as any other factor - is one of the single-biggest justifications for all sorts of things that we take for granted today, including:

• Mark-to-market accounting systems.
• The concept of total returns.
• Efficient frontiers .
• And even various stock-rating systems.

Market efficiency even provides the underpinning for the so-called “ prudent man ” rules that are so critical to ERISA (Employee Retirement Income Securities Act of 1974) funds and the entire money-management industry, not to mention much of the Financial Accounting Standards Board (FASB) regulations.

Well, at the potential of really igniting an e-mail bonfire, we need to ask ourselves: If the markets are truly this efficient, why do all the research? Why would we have an entire industry of analysts who are collectively paid billions of dollars a year to ferret out information that the efficient-market hypothesis says is already reflected in current market prices? In fact, why would we even have the concept of “insider trading” to deal with or be so concerned by American International Group Inc. ( AIG ) type bonuses or even the Federal Bailouts if things were truly “known?”

The inconvenient truth is that the markets are wildly inefficient and they can be so for much longer periods of time than people realize - or that “experts” would admit.

Moreover, as my own research shows, the markets are neither one-dimensional nor three-dimensional, and they are also not characterized by “ log-normal distributions .” They are, in fact, fractal creatures that can shift from trending to non-trending in an instant. And they are increasingly characterized by something called “fat tails.”

When you hear that last term - and you will with increasing frequency in the years ahead - it will be most associated with huge market moves that had previously been unthinkable, or regarded as impossible. Nassim Nicholas Taleb does a great job of describing them as “ Black Swans ” in his book by the same name.

For most people, this will be a discussion best accompanied by a stiff drink - so you can skip the next few paragraphs if you like. The important thing to understand - and to come to terms with right now - is that the “impossible” happens a lot more than its label implies.

In recent years, people have become entirely too comfortable with the notion of “normal” markets and that's one reason why so many investors are hurting so badly now. They came into 1999, and into 2007, with portfolios that were too heavily weighted in stocks and other holdings that relied on “normal” market behavior and historical precedent. Those investors sealed their own fates by believing that the fancy diversification graphs they got from Wall Street investment houses would protect them; instead, they discovered that diversification doesn't work when everything goes down together.

It's one of Wall Street's dirtiest secrets and has emerged as one of the most hotly debated topics in Washington today.

Research (mine and that of others who are a lot smarter than I am) suggests that conventional diversification theory based on lognormal market distribution actually camouflages risk, instead of reducing it.  That's why companies such as AIG, Lehman Brothers Holdings Inc. ( LEHMQ ), and others, got into so much trouble. By placing their trust in errant models, the quants that were supposed to be protecting the hen house let in the foxes without ever realizing what they had done.

The experts' mathematical models were supposed to account for “normal” conditions. Nobody asked what would happen when the improbable black swan showed up. And if they did ask, they sure as heck didn't pay attention to the answers, because it may have ruined their plans for multi-gazillion-dollar bonuses. I can't tell you how often in recent months I've heard insiders protest with comments and observations that “the markets aren't supposed to do that.”

This is really neither here nor there though. For every day investors, the critical part to understand is that the markets are demonstrating behavior that's supposed to be impossible on a much more regular basis than people realize.

Take, for example, a November study from Cook Pine Capital LLC . Like my own research, the Cook Pine study shows that in the last 81 years of Standard & Poor's 500 Index data, so-called “ three sigma ” (or three-standard) deviations happened more than 100 times. Conventional log-normal modeling of the type AIG and others used heading into this crisis suggested that such events should have occurred only 27 times.

Oops.

And that's not even as bad as it gets.

The Cook Pine study also demonstrated that the likelihood of a four-standard-deviation move on any given day is one in 100. Yet we've seen 43 of them since 1927. And even a five-standard-deviation move, which is theoretically impossible from a statistical standpoint, has happened 40 times in the last 81 years, including eight times since September alone.

This is precisely why I frequently point out to investors that while using conventional diversification is better than nothing, it's often akin to rearranging the deck chairs on the RMS Titanic .

You're much better off just getting off the boat altogether.

The rules of money have changed and this kind of data suggests that it's how you concentrate your wealth that matters, particularly when it comes to avoiding the improbable - and even profiting from it.

One of the simplest ways to do this is through the use of non-correlated investments that zig when everything else zags. In the old days, that meant having exotic futures accounts or taking positions opposite to the markets entirely using margin accounts to sell individual stocks short - one stock at a time.

Unless you had a fair chunk of change to put into a managed account, chances were that you couldn't effectively mitigate the risk of the unknown. Of course, traditional Wall Street brokerages dismissed futures for a long time, so that didn't help. But that's another story for another day.

What matters now is that there's an entirely new class of “inverse” investments available to individual investors. Unlike managed-futures accounts, there are no account minimums and no active management fees. Most are available through online discount brokers and can be purchased just like stocks.

I've talked about these for years and I am absolutely amazed that more investors don't use them.

Actually, I'm astounded.

Inverse funds, as their name implies, go up in value when the markets go down. There are plenty of choices to consider, with everything from the S&P 500 to specific sectors available in the mix. There are even double and triple inverse funds out there, which use swaps, futures and options in a fashion that allows them to move two or three times as much as the investment vehicles to which they are linked.

Of course, if the markets go up, the reverse is true and these things can lose money in a real hurry, so one can't just pile in indiscriminately.

My research and that from groups like the CME Group Inc . ( CME ) and Chicago Board Options Exchange (CBOE) suggests that an allocation equal to 1% to 5% of your overall assets is about right when it comes to enhancing overall returns and lowering portfolio risk. Aggressive investors who take on as much as 20% in non-correlated assets can dramatically lower their “drawdown” in a bad market (from 41% for a stocks-only portfolio to only 7.5% for a diversified portfolio), while increasing their overall returns (from 7.4% for that stocks-only portfolio to 8.9% for the diversified portfolio). This holds even though they used parametric distributions to plan such things.

These are important lessons to take away from these troubled times. If you embrace such a strategy, chances are that you'll not only be smiling on down days in the market but you'll also come to actually enjoy the unpredictable markets we now live in, too.

[ Editor's Note : As Money Morning Investment Director Keith Fitz-Gerald demonstrated in this essay, the ongoing financial crisis has changed the investing game forever, making uncertainty the norm and creating a whole set of new rules that will quickly determine who wins and who loses in today's global investing markets. Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as " The Golden Age of Wealth Creation ." His key discovery: Despite the gloom, investors may well be facing the greatest profit opportunity of their lifetimes.

In his newly launched Geiger Index investing service, developed after more than a decade of work, Fitz-Gerald has amassed a winning streak of profitable picks. Check out our latest insights on these new rules, this new market environment , and this new service, the Geiger Index .]

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