We often hear about an undervalued asset, an unfair exchange rate, or an overvalued dividend forecast. In my opinion, such "expert" statements can not be trusted, but serve as a sign of speaker’s ignorance. In such case, the person puts his opinion above the market's efficiency, although often such radical forecasts are carried out simply by virtue of the theory of probability.
Many are confused, so I’ll briefly remind you that "market efficiency" is understood as its ability to reach a fair price of an asset at any given time. This does not mean at all that an "efficient market" should effectively bring in money to investors and managers, although such a bundle can often be heard from analysts.
Arguing to their trading ideas, very often for the sake of wit, "experts" throw quotes from behavioral finance theories and effective market analysis into a discussion. They sound convincing, but as a rule, it does not indicate in any way that it is reasonable to accept these ideas. It is important to understand the terms here, and you will be able to find similar, sometimes funny, errors in analytical reviews.
The essay below briefly explains the essence of these two theories. From myself I will add that I have always believed that it is only the market which is always right. It is made by people and the robots created by them, and it is the diversity of their opinions and strategies that makes it possible to adequately evaluate this or that tool. Good luck!
A game for fools?
Of course, behavioral finance experts recognize the role of diversity in pricing. Here is what Andrei Shleifer writes in his remarkable book "Inefficient Markets: An Introduction to Behavioral Finance":
The hypothesis of an effective market is not confirmed and is not refuted by the assumption of investor rationality. Many models based on the irrational behavior of some investors, nevertheless, predict efficient markets. The argument is usually given the case when irrational investors in the market trade as necessary. If there are a lot of such investors and if their trading strategies do not correlate with each other, their transactions will neutralize each other. As a result, in such a market ... prices will be close to the base value.
The problem is that in behavioral finance, a variety of investors is seen as the exception rather than the rule. Shleifer continues:
"This argument relies mainly on the lack of correlation of strategies among irrational investors and therefore applies to a rather narrow circle."
Finally, Shleifer argues that arbitration - another mechanism that brings prices into line with fundamental value - is risky, so the possibilities for arbitration are in reality limited.
Thus, Shleifer makes the following conclusions: since investors are irrational, and their strategies are more often correlated than not, markets are inefficient. In addition, arbitration may not always make the market efficient. Therefore, market inefficiency is the rule, and efficiency is the exception. And active portfolio management in a fundamentally inefficient market is a game for fools.
We believe that the majority of professional market participants believe exactly the opposite: market efficiency is the rule, and inefficiency - the exception. After all, we see how, in many complex systems, diverse decisions and actions of individuals create rational outcomes. The team invariably replays the average individual. An investor ecosystem on the market is usually sufficient to ensure that there is no systematic way to replay the market. Thus, diversity is assumed to be the default, and loss of diversity is always a notable (and potentially profitable) exception.
See money, imitate money.
If diversity generates an efficient market, then the loss of diversity makes the markets prone to inefficiency. In short, if you turn to behavioral finance as a tool for finding investment opportunities, then look for them at the collective level.
A good example is the herd when a large group of investors perform the same actions on the basis of observing others, regardless of their individual knowledge. From time to time in the markets there are periods when any one mood begins to dominate. Such a loss of diversity usually leads to a market boom (everyone becomes bull) or sharp falls (everyone becomes bear).
As far as I know, there is no tool that would accurately and consistently measure the level of diversity in the market. Good hints can give an objective assessment of publicly expressed in the media and private opinions. The key to successful counter investing is to focus on the behavior and mistakes of the crowd, not its individual members.
