If you ever took an economics course, your professor may have convinced you that you could never beat the market. Yet time and time again, common events prove that you can do better than the market averages.
One of the first things you learn about economics and the stock market is the efficient market theory. Although the theory is complicated and takes several different forms, it boils down to the idea that the stock market incorporates all available information into a stock's price. Because the current price already reflects every piece of news that anyone knows -- even if you don't know it -- the theory says that you can't expect to do any better than any other investor.
Yet nearly every day, we see examples of stock price movements that run counter to the entire concept of the efficient market theory. And while some might use these examples as proof of Wall Street corruption, they're actually good news for investors -- because it means that you can beat the market.
Analysts and the herd
Where can you discover these inefficiencies? They're easy to find: Just take a look at the list of analyst upgrades and downgrades on a given day. According to the theory, analyst recommendations should carry very little weight, because any given analyst shouldn't have any more information about a company than other analysts or even the public at large.
But if analyst recommendations are in fact worthless, the stock market certainly doesn't react that way. Often, stocks make huge moves in response to analysts' opinions about their prospects. Here are a few examples just from the past week:
|
Stock
|
Upgrade/Downgrade
and Date
|
Price Move on Day of
Upgrade/Downgrade
|
Overall Move for
S&P 500 on Same Day
|
|
Morgan Stanley
(NYSE: MS )
|
Outperform to Neutral, April 2
|
(2.6%)
|
2.9%
|
|
Autozone
(NYSE: AZO )
|
Buy to Hold, April 2
|
(5.1%)
|
2.9%
|
|
Apollo Group
(Nasdaq: APOL )
|
Outperform to Neutral, April 1
|
(15.2%)
|
1.7%
|
|
Alcoa
(NYSE: AA )
|
Sell to Hold, March 31
|
9.7%
|
1.3%
|
|
Microsoft
(Nasdaq: MSFT )
|
Neutral to Buy, March 31
|
5.1%
|
1.3%
|
|
The Knot
(Nasdaq: KNOT )
|
Buy to Hold, March 31
|
(7.4%)
|
1.3%
|
|
Mosaic
(NYSE: MOS )
|
Buy to Hold, March 30
|
(9.2%)
|
(3.5%)
|
Source: MSN.com, Yahoo! Finance.
You can see the dramatic impact that analyst recommendations have on stocks. Despite the fact that the information those recommendations are based upon is readily available to anyone who puts enough effort into finding it, the fact is that many investors don't bother trying to gather all the information they could get before making a decision to buy or sell shares. Instead, they rely on paid professionals and reflexively follow the herd.
Why that's good
Economics students may feel betrayed when they first learn that the efficient market theory doesn't perfectly reflect the reality of the stock market. But you should actually be happy about it. Because most investors don't invest with perfect information, you can gain an advantage over the crowd by knowing more than they do.
You can exploit that knowledge in many ways:
- Some investors look to small-cap stocks because most of them don't have a wide following among Wall Street analysts, making their markets more inefficient.
- Others focus on international stocks, counting on the predisposition of U.S. investors to shun foreign companies as being too risky or unpredictable to justify holding in their portfolios.
- Any number of other investors concentrate their efforts on obscure segments of the market, from closed-end mutual funds to corporate bonds, as a place to gain an advantage over common investors.
No matter which avenue you choose, however, be glad that the efficient market theory doesn't work. With a lot of work, the inefficient market means that you can find ways to profit that other investors will miss -- justifying the effort you spend seeking out the best investments you can find.
For more on how you can beat the market:
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