Eschewing Efficient Markets

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Most columns concerning investments or economics make certain assumptions concerning behavior in and characteristics of markets being discussed. It is taken for granted, for instance, that market participants are behaving in their own self-interest (profit motive), that they are relatively free to act at any given time, that there is minimal government intervention beyond standard rules, regulations, taxes, etc.

Another such assumption typical of columns including this one is that participants (investors) are dealing in what are commonly called efficient markets – markets that do not restrict who can participate or how they act.

In other words, an efficient market should – in theory – represent the sum total knowledge of all participants within that market in real time because each participant is taking certain immediate actions based on their individual expectations with their own self-interest in mind and without restriction.

But what happens when markets aren’t efficient?

It’s important to first understand that markets are not necessarily efficient. Depending on the market, there may be numerous barriers to entry, or participants may be restricted from taking actions without delay. In many cases, the role government plays in a particular market may be large (e.g. pharmaceuticals), making resources like lobbyists an advantage to certain participants.

Quite often successful investing can be achieved by exploiting such market inefficiencies. While this can be achieved in tradable securities (like those listed on the New York Stock Exchange or comprising the Dow Jones Industrial Average), it’s extremely difficult simply because these markets are so large and there are so many participants – some of whom will naturally be more informed.

It can be much easier to find and exploit market efficiencies where they are more obvious. This often occurs in smaller markets, which are naturally less efficient because they have relatively few participants, and/or limited capital flowing in, out, or around.

All this reveals in a very roundabout way that, quite often, investors are very well served by looking for small scale investment opportunities. Such investments can represent tremendous potential for profit because they may not be available to or recognized by other participants, who may be few in number.

The following are examples of people entering what were at the time extremely inefficient markets and finding large-scale profit as those markets gained participants and became more efficient:

  • Bill Gates and Paul Allen entry into the personal computer industry
  • Henry Ford’s pioneering of assembly line production for automobiles
  • Joseph P. Kennedy’s early involvement in financing the motion picture industry
  • Cornelius Vanderbilt’s transition from steamships to railroads
  • Johannes Gutenberg’s invention of the printing press (known mostly for printing the so-called Gutenberg Bibles)
  • Samuel’s Colt’s innovations in repeating firearms production

Most people don’t think of starting their own business in this way, but such ventures are perhaps the best examples of profiteering from inefficient markets. Founders of such enterprises identify a need – a niche – and attempt to come up with a practical, economic solution in a way that also benefits them personally.

It's startling how few people ever consider the idea of starting their own business. It seems more and more people, especially from generations X and later, prefer maintaining steady “9 to 5” jobs without ever venturing out on their own.

Our hope – if America is ever to regain the status it once held as an economic superpower – is to see more ordinary citizens hanging out shingles and trusting in their own problem-solving skills. It is only through ingenuity and hard work that American will regain the prestige it once enjoys.

With any luck, changing their perspectives to recognize new ventures as ways to take advantage of inefficient markets – something they’d be hard-pressed to do trading stocks – will encourage more people to do just that.

Dock David Treece is a partner with Treece Investment Advisory Corp (TreeceInvestments.com) and is licensed with FINRA through Treece Financial Services Corp. He provides expert content to numerous media outlets. The above information is the express opinion of Dock David Treece and should not be construed as investment advice or used without outside verification.

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