An important point, philosophy, or whatever is the fact that “the market” is not efficient.

This flies in the face of much academic theory stating that the markets are efficient, and that one assumption is the basis for much of the modern portfolio theory (MPT) and capital asset pricing model (CAPM). That one assumption is why these are both flawed theories (even nobel winners can be flawed).

The market (and in this way I refer to markets in general, not just the equity markets) is not efficient, it is instead an efficiency process. This is important, as it explains why any of us can take above average profits out of the market over the long term. (The average profits would be dictated by the growth of the economy.)

If the market were truely efficient, no trading would take place, or at the very least much, much less trading would take place (a few brave souls would force trades to occur when they needed to re-balance asset allocations, sell to pay for a vacation home, etc.). If everyone agreed on the price of Microsoft or IBM, there would be no reason to buy or sell. The bid/ask spread would simply frame the consensus value and that would be that. All new public information would immediately be reflected in the bid and offer.

What we have instead is a lot of market participants trying to ascertain true value, and voting with their own dollars. Those that are smarter, quicker, and have better research will buy when a price is below their assumption of value and sell when the price is above their value. Through their actions, their buying and selling (their process, if you will) can contribute to the market’s efficiency over time.

Those with discipline and insight can take above average profits from the market and continue to do so because the market is often wrong. There is typically no new real fundamental information revealed to the market on any given day, yet the prices change. Every time we see a trend in price action, it is the result of the process of the market participants spreading (or realizing) the understanding of the real value. Over time, this should lead to an efficient price, but it’s a journey, not an end point.

Like Warren Buffet opines, “The stock market is there only as a reference point to see if anybody is offering to do anything foolish.” When someone else in the market does not have as much information or understanding of underlying value as you, you have the opportunity to help the market be more efficient by helping the fool part with his money. Jim Rogers is more blunt and extreme when he says, “the market is always wrong.” They both have the profit records to prove it too.

Emotional market participants, those sell in a panic or buy on eurphoria… those who trade on a “greater fool” (or “slower fool“) theory… those who know the price of everything but not the value… they’re are apt to make the market less efficient in the short term.

Of course, an efficiency process takes time. How long did it take for the Nasdaq take to go from 5,000 down to a value that wasn’t utterly preposterous? Years… and some would argue that we’re not there yet.