The art of profiting from market inefficiencies

As the stock market becomes more inefficient due to low interest rates, excessive indexing, and social media-driven speculation, savvy investors can find mispriced assets for potentially higher returns – though it comes with more risk.

• In an increasingly volatile market, staying the course with a long-term strategy and a diversified portfolio is crucial. Don’t get rattled by short-term underperformance; it’s about overall stability
• While it’s tempting to chase the latest trends, focusing on proven, long-term strategies like value investing will likely yield better results over time. 

In an ideal world, stock prices would reflect all the information that’s out there. That would mean that shares are neither cheap nor expensive – everything is priced just right. But markets aren’t perfect, and inefficiencies can creep in. The question is how far they spread.

In his latest research, Cliff Asness – chief investment officer at AQR Capital – noted that the stock market, once deemed to be a tight ship, has been slackening. And its growing inefficiencies have some logical implications for how you invest.

What’s driving all this inefficiency?

According to Asness, there are three major culprits:

1. Low interest rates. When borrowing is cheap – like it was from 2009 to 2022 – investors, desperate for returns, start taking chunkier risks. This naturally leads to stock prices drifting away from reality, as people bet big on anything that might give them a half-decent return. But this seems like less of a contributing factor now, with interest rates so much higher than before.

2. Too much indexing. Over the past few decades, indexing – in other words, investing in broad market indexes like the S&P 500 – has soared in popularity. And while the trend seems harmless enough, it comes with a downside. Indexing assumes stock prices are already efficient. And when more people use this strategy, fewer investors pay attention to individual stock fundamentals, leaving share prices free to drift away from reality.

3. Tech and social media. This one is huge. While you’d expect more accessible information to improve market efficiency, it’s actually done the opposite. Social media, real-time stock data, and trading apps like Robinhood have encouraged short-term speculation. Retail investors can now trade stocks instantly, but instead of using that access to make independent decisions, they often follow whatever’s trending online. The GameStop Corp Class A (NYSE:GME) and AMC Entertainment Holdings Inc Class A (NYSE:AMC) meme stock frenzy of 2021 is a prime example – those price moves were based not on solid fundamentals, but on hype.

How does all this affect you?

Inefficiency in the market leads to greater mispricing of stocks, and opportunities for higher returns. If you're savvy enough, you can find the misjudged assets or undervalued stocks that others overlook, especially in less popular markets or sectors. After all, value investing makes even more sense in an inefficient market. That said, while those investments may be more rewarding over the long haul, they also carry greater risk.

In theory, the more mistakes others make, the more you can profit. But here's the catch: it’s much harder to pull off. Periods of underperformance will be more painful and drawn out. You might spot what seems like an underestimated gem, but the market could take its sweet time in recognizing its value. On the other hand, overpriced stocks can stay bloated for way longer than you'd expect, tempting you to jump in just before the bubble bursts.

So what can you do?

1) HODL

In the meme stock world, HODL stands for "hold on for dear life" and it’s often applied to sketchy, overhyped companies that are teetering on bankruptcy. But if you apply HODL to solid, well-reasoned long-term strategies, it’s actually a great motto. Investing is a long game, above all else. Markets have their ups and downs, but the folks who stay calm and resist the urge to panic-sell usually come out ahead. Historically, markets recover, and fortune favors those who are patient. 

2) Diversify

Shift your focus from individual "line items" (like specific asset classes or geographies) to the big picture: your whole portfolio. Yes, an investment will disappoint you now and then, but that’s just how diversification works. What’s important is keeping that long-term perspective and remembering that the whole collective mix is what counts. Some parts may lag, and others may sprint ahead, but the goal is overall stability.

3) Forget the fads

It’s tempting to follow the latest market trends, but it’s far better to focus on a longer time horizon – think three to five years. Momentum investing might work over a few months or even a year, but over longer periods, most things tend to reverse course. So while it's okay to ride the wave in the short term, over the long haul, being a bit of a contrarian pays off. Focus on proven strategies like picking value and quality stocks – the overlooked ones with great potential.

Good investing has always required two things: figuring an opportunity and sticking to it. As markets have become less efficient, the first part has become easier, but the second has become tougher. And those shifting dynamics can tell you where to focus your energy.

Theodora Lee Joseph is an analyst at finimize.

ii and finimize are both part of abrdn.
finimize is a newsletter, app and community providing investing insights for individual investors.
abrdn is a global investment company that helps customers plan, save and invest for their future.