In the last article, we have seen that what is 2nd level thinking and how we can able to take benefits from 2nd level thinking. In this article, I am going to discuss my learning from the 2nd chapter of the book “The Most Important Thing”. This chapter talks about efficient market theory and how we can use it for our own benefits to earn an above average return.
So first, we need to know what is an efficient market hypothesis?
Source: The Most Important Thing by Howards Mark
According to the efficient market theory, it is not possible to earn a consistently above average return due to the availability of information with each and every market participants at the same time. And also, there are many investors who tracking real-time information and make a decision based on this information. Due to this hard work by an investor, the price of securities reaches at fair value easily.
We can see in the above chart that as the quarterly result get announced, many of the investors have made an effort to analyze available information and stock price reaches to the fair value.
So, that We cannot ignore that theory is not relevant to the practice.
Source: The Most Important Thing by Howards Mark
As per the above criteria, Bank Fixed Deposit is one of the suitable examples of the efficient asset class among all other asset classes. Bank FD can pass through all above criteria and due to its efficient nature, we cannot able to get an above average return from Bank FD, even cannot able to earn higher than the inflation.
We must have to agree with the parameters that investors work hard for analyzing each and every available information for reaching towards some conclusions. And additionally, everyone having the same access towards all information. So, that we cannot able to make an above average return consistently over a longer period of time.
So, those companies which are tracked by more and more analysts, FIIs, and retail investors then chances of getting an above average return will reduce. Thus, we have to focus on the companies which is different and where we can able to get the edge for creating an above average return.
If we take an example of the huge wealth creator company with every 5 years’ interval, then
So, this stock has given a huge return when not much known to the investors (i.e. inefficient) and as the stock becomes known to all (i.e. efficient), speed & rate of return start falling.
As we agreed with the parameter that every investor works hard, but what about the emotional interference for making a decision? Is it really easy to control our emotions while making any decisions?
Also, the psychology of all investors influences the decisions taken by them, which creates misprice opportunity for us. All investors react differently to the same information due to their emotional influences.
If any news regarding company comes then everyone can get it at a similar time (I am considering everyone accessing information at the same time) but the interpretation of that news is different with different participants.
Everyone gets the news of the fire at the plant of the company at the same time. But some people analyzed that this will incur an additional loss to the company & starts feeling far from this news and started selling out their positions. And some will use second level thinking to buy that same stock at an available discount due to temporary reasons.
So, that’s how to use information & capturing mispricing opportunities is dependent on skills and emotional ability of individual investors and that helps them to make an above average return.
Also, we should not ignore theory because theory helps us to limit our focus on mispriced opportunities rather focusing on all the available opportunities. We have to open for analyzing all the unknown opportunities with using of 2nd level thinking. Then and only then we can able to catch up opportunities to getting above average returns.
Many a time, we get an opportunity which is avoided by others or others are not willing to grab those opportunities. We have to identify mispriced opportunities and have to take benefits from such inefficiency.
Every most efficient opportunity is mispriced opportunities at once upon a time. So, that we have to limit our focus on identifying misprice opportunity. As I quoted in the above example of fire at the plant of the company. As that company is widely tracking by many investors, FIIs, DIIs etc., but capturing opportunity when it becomes a mispriced opportunity that is the importance of skill (Obviously with important of LUCK).
Also, we should try to capture the opportunity which is not well known and not tracked by many of the investors. By this, we can able to limit our focus and can able to generate an above average return.
Read for more detail: The Most Important Thing Illuminated by Howard Marks
Above article is just my perception, and perception can be wrong. For me, my perception can be right but for others, it might be wrong.