“Channel Investing”: The Only Way To Beat The Efficient Market Hypothesis
There is a way to beat the market. To understand how it is possible, we must first understand why it is so difficult and why the vast majority of traders never accomplish it.
In a nutshell, the barrier to truly spectacular gains is “efficient markets.” As you may know, the efficient-market hypothesis is one of the most important insights into equity trading ever developed. First, I’ll give you the Wikipedia definition. Then I’ll add to it and tell you how to overcome it. Wiki says:
In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient.” In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
In other words, so much information is available to so many traders all the time, it is nearly impossible for one person to glean something from the blizzard of information and disinformation available online to consistently outperform all the others trying to do the same thing.
This is true. There is a way, however, to beat the traders. The technique is a radical financial strategy called “investing.”
Yes, I’m being somewhat facetious, but it’s true.
Historically, investors who did their homework and identified technological innovations before the mass of traders began trying to predict every micro-movement in a stock have been able to reap legendary gains.
This is possible for a number of reasons. One is that the vast majority of traders are not experts at anything except following trends.
They are generalists almost by definition. Therefore, an army of generalists is constantly reacting to the tiniest, most trivial bit of data, trying constantly to predict what all the other generalists will do.
The odds of winning this game, once you realize that the brokerages play the same role as “the house” in Las Vegas, are dismally low. I have a friend who has run several major brokerages who tells me that he and everybody else in that business know this is true but will never admit it.
Investors, however, have the option of actually doing the work and learning about emerging technologies. Armed with sufficient understanding of specific innovations and overall economic forces, investors in breakthrough technologies can earn huge returns. I use the word “earn” purposely, by the way. If you hear somebody use the word “win” or “won” in the stock markets, you know they are gamblers, not investors.
Investors don’t constantly buy and sell trying to outguess the market, which is exactly what brokerages want you to do. Investors do the work to understand where science and technology are going and buy equities in companies, not stocks, positioned to profit from the constantly changing technological environment.
This is actually a very difficult thing to do, for psychological and emotional reasons. People tend to watch tickers too closely and fall prey to the herd mentality. I tell people, however, that it is far better to sit on a transformational stock that doubles in value for five years than it is to try to win 10% or 15% gains in the short run.
The calculated annual ROI of a successful short-run trade is, on paper, huge. The fact is, however, that virtually nobody constantly wins short-run trades. Only supercomputers on the floors of the exchanges do that. Traders who average 20% gains yearly are nearly nonexistent. If you have the patience to invest in companies that can double or triple in a five or so year cycle, however, such returns are absolutely feasible.
You hear about big trading success stories, however, as traders are likely to brag about those “wins” while ignoring their losses and charges. Brokerages also tout those instances, just as the casinos issue press releases when somebody wins big at slots. Neither brokerages nor casinos put out press releases showing the vast majority of gamblers slowly turning over their wealth to the house.
Investors often buy only once and sell once many years later. Some sell at various points in the upward movement of a company’s stock to lock in gains or get cash to buy additional equities when markets inevitably dip. Investors who indulge in this sort of trading are actually engaging in “price averaging” and can make truly spectacular gains, as quite a few of my readers have demonstrated.
The key, however, is that the trades are meant to bolster an investment, not outperform the gamblers.
Price averaging is simply adding to your holdings of companies that you believe will increase in the long run. I also call this channel trading because many early-stage innovation companies vacillate regularly in pretty well defined channels. Armed with enough information about those patterns, it’s not that hard to buy after a stock goes down and sell some after it goes back up — keeping in mind that the true point is to add to long-term holdings at low prices.
The key point about this strategy is that the channel traders’ buys and sells take place “after” movements. Unlike traders trying to predict movements and place their orders before the herd stampedes, channel investors can sit back, watch the herd and profit by increasing their ownership of companies in a diversified portfolio of transformational technologies.
This is the only way to beat the efficient-market hypothesis, because it’s based on knowledge that traders simply don’t bother to learn. It often involves relatively complex science and even some basic knowledge of math and statistics. While it is simple in theory, it’s very difficult to stay calm and stick to your guns while investors are shouting and waving their arms around like branches in a hurricane.
Patrick Cox, for Penny Sleuth
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