In addition to the fact that the overall market can be dominated by market sentiment, certain sectors are particularly prone to inefficiency. There are several reasons why one financial market may be more inefficient than another. Two of these reasons are: society has, for some reason, developed a bias towards it, and it is more complicated to understand.
For example, financial analysts tend to pay particular attention to the stocks of large companies. This trend is partially a by-product of the way the investment banking industry works, but is also due to the stature that “large-cap” stocks hold in society. People want to know how Apple (AAPL) is doing, and, every day, thousands of intelligent people pour over its financial statements trying to figure out where the company is headed.
Trying to get an edge over the competition for these kinds of investments is exceptionally difficult, if not impossible, in normal markets. There are very few glaring inefficiencies for the stocks of these types of companies unless animal spirits are taking hold of the economy as a whole.
In the process, other investments are monitored by far fewer people, requiring some knowledge of asset class diversity and common equities. “Small-cap” stocks, for example, can often slip through the cracks of large institutions’ financial analysts and go unmonitored.
Many large institutions are required to move so much capital when they invest that they are restricted to companies of a certain size. Their restrictions open up opportunities for investors with more nimble capital, who are able to invest in all companies, large and small.
High-yield-bonds are another sector which is notorious for mispricing. Any investment which, for some unfounded reason, has a stigma against it leaves room for objective, informed and diligent investors to earn higher returns without more risk. Moreover, short-term, relative performance mentalities create a herding phenomenon, which causes money managers to buy and sell securities at approximately the same time
There are also investments which are stigmatized because they are too complicated for generalist investors. Some sectors require inter-disciplinary approaches, such as investing in companies on the brink of bankruptcy (called “distressed” investing).
This strategy requires interplay between finance professionals and legal professionals. Naturally, there are significantly fewer investors in these more complex sectors. Of course, investors must be more careful when dealing with these types of investments, but specialists in a generalist investment field often earn higher risk-adjusted returns for themselves and for their clients.
Pondering market inefficiencies equates to asking why everybody does not eat well, or exercise every day. The truth is that value investing, although simple, is far from easy. It requires diligence, intelligence, good judgment, and tremendous amounts of patience and self-control; much like staying healthy does. Investors need to use deep analysis, buy securities with conviction and then withstand what can be frightening amounts of volatility. Both require knowledge and patience.
Warren Buffett’s two-cents on stocks and market efficiencies is probably the most sought after piece of advice the entire financial world over. Arguably one of the savviest investors in the entire world, Buffett has been the model for what amateur and budding investors want to achieve. The irony is that while a lot of people aim to be like Buffett, not that many are willing to take his advice. When it comes to an efficient market, due diligence and Buffett-like advice should be sought like gold, lest we lose money egregiously.