The market really is inefficient

A new, in-depth study suggests that it really is possible to beat the market, says John Stepek – you just need to know how.


Momentum: it works in stocks too
(Image credit: whitetag)

A new, in-depth study suggests that it really is possible to beat the market you just need to know how.

In theory, you shouldn't be able to beat the market consistently. That's the basis of the efficient market hypothesis, and it's the main rationale for buying an index fund (one which simply tracks the market), rather than trying to pick one of the few individual active fund managers who does manage to beat the market regularly, whether through sheer luck or unusual levels of skill.

However, as we all know, theory and practice often diverge. While it is by no means easy to beat the market, there are various styles or "factors" that have been shown to deliver market-beating returns over the long run, by taking advantage of apparent anomalies.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Now a fresh piece of research has taken a look at just how durable these strategies have been over time. Global Factor Premiums, a paper from Dutch investment group Robeco, by researchers Guido Baltussen, Laurens Swinkels and Pim Van Vliet, takes data stretching back more than 200 years, and looks at how six of the most popular factors have performed in equities, government bonds, currencies and commodities.

To cut a long story short, the researchers found that in most cases, the investment styles showed compelling evidence of outperformance; that they worked consistently over time (clearly they didn't beat the market all the time, but there was no obvious point at which any of the strategies simply stopped working); and that they were not obviously correlated to any particular investment backdrop in other words, they worked in both good times and bad times.

So what are these styles? The most effective was trend-following, which quite simply involves buying what's going up and selling what's going down. The similar strategy of momentum (buying stocks that perform well relative to others) was not quite as effective but still worked.

The other four styles were: seasonality (whereby different asset classes do well at different times of year); carry (high-yield assets beat low yield); value (cheap assets beat expensive ones); and finally, "bet against beta" whereby investing in the least-risky assets delivers higher returns than buying the most risky ones.

The findings are striking on several levels perhaps we need to rethink our scepticism about the old "Sell in May" adage, for example. But perhaps the most useful for a private investor is that it suggests another useful dimension beyond geography and asset class, across which to diversify your portfolio. In particular, it suggests that, regardless of your views on the efficacy of technical analysis, you shouldn't dismiss trend-following as an investment strategy. And nor, despite its poor showing since the financial crisis, should you give up on value.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.