The market really is inefficient

Newton's cradle © iStock
Momentum: it works in stocks too

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.

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.