Inefficient Market Theory: An Investment Framework Based On The Foolishness Of The Crowd

(MENAFN- ValueWalk)

Efficient Market Theory is based largely on the concept of crowd wisdom - that a large group of people casting their collective votes in the stock market produces correct stock prices and hence an "efficient market." However, we know from experience that the stock market is not entirely efficient, and sometimes produces wildly incorrect prices. This book explores the various criteria that are required for crowd wisdom to manifest in a financial marketplace, these being: 1) incentives; 2) independence; 3) diversity of opinion; 4) decentralization; 5) knowledge; and 6) rationality. A fundamental premise of this book is that a proper understanding of crowd wisdom criteria, and the ability to detect when these criteria are lacking in the market, is a significant benefit in identifying mispriced securities. In particular, this book explores the various behavioral and psychological biases that affect market participants, what we call the "Foolishness of the Crowd." The predictability of this Foolishness, i.e., the predictability of these biases in a crowd setting such as the stock market, produces reliable offsets from crowd wisdom, i.e., stock mispricings. This book then proposes an investment framework based in part on the investor's "inefficient rationale" - his articulated understanding, based on the above crowd wisdom criteria, as to exactly why the market is mispricing a particular stock. The investment framework also utilizes the wisdom from a select value investing crowd to both identify and help confirm good investment opportunities. The investor who adheres to this investment framework essentially places the full benefit of crowd wisdom and knowledge into his corner, including both the wisdom of the crowd and predictable departures from this wisdom.

Measuring Returns

This essay discusses various methods of calculating returns--simple rate of return, time weighted rate of return, and internal rate of return. In particular, the essay shows how each return is calculated, discusses common uses of those returns, and provides illustrative examples.

Cost of Leverage

This essay relates to the "Cost of Leverage" of various different leveraged vehicles for investing in common shares, such as using margin or purchasing calls or warrants. Additionally, the essay explores the relationship of Cost of Leverage as the degree to which the call or put is in or out of the money.

Price and Returns

This essay relates to the relationship between price and returns. In particular, the essay explores how returns develop over different holding periods, underlying value growth, and prices paid relative to that underlying value.

Why Hold Cash?

This essay relates to determining if and how much cash should be held in a portfolio to produce superior long-term results. In particular, the essay is devoted to determining whether or not it makes sense to hold cash when compelling investment opportunities still exist, e.g., in order to take advantage of an upcoming downturn, based on valuation metrics, etc.

The Hurdle for Active Investors

Building on "Holding Period, Taxes, and Required Performance", this essay focuses on determining how much an active investment must outperform a passive investment, such as an index fund, over the same investment period under various situations. Initially, the essay determines appropriate scenarios for comparing the active investment to the passive investment, based on a history of returns and dividend yields from 1871 to 2013. After determining these scenarios, a representative set of variables, including annualized gains, turnover, investment period, dividend yield, and tax rate, are modeled in order to determine the hurdle for the active investor.

Holding Period, Taxes, and Required Performance

This essay focuses on the impact of taxes on pre-tax returns over various holding periods, from less than a year to 20 years. Initially, the essay shows the required pre-tax returns required to generate 10, 12, 15, and 20 percent after-tax returns for holding periods from 1 year to 20 years. After some discussion of this relationship, the essay then turns to holding periods of less than a year, and similarly calculates required pre-tax returns to generate 10, 12, 15, and 20 percent after-tax returns at different tax rates from 20% to 39.6%.

Know Your Graph

This essay provides a framework for understanding risk at its fundamental level. Instead of measuring risk via beta or volatility, as is the current common practice, risk should be understood as the probability of loss. Even further, since there are many possible future outcomes, results cannot be easily used to evaluate the risk undertaken to achieve those results.

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