Capitalizing on Market Inefficiencies in Global Stock Markets
June 30, 2013 | Topics: Alternatives
- Market inefficiencies create opportunities for enhanced return for investors
- A long/short strategy gives an investor many options for taking advantage of inefficiencies
- An investor can use a long/short strategy to manage their market exposure and the effects of market volatility
Market Inefficiencies Create Opportunities
Investors often assume that the markets they are invested in always work properly and run smoothly, but the truth is that they don't. Market inefficiencies exist in all markets and they can present savvy investors with more opportunity and enhanced return. However, they are easier to spot in some markets than others. Not only are they sometimes more obvious, but in some markets an investor may have days to act on an inefficiency once it is present, while they may have only minutes or seconds in other markets. Even though all markets have inefficiencies, some are just harder to identify and act upon.
Case Study: Emerging Markets
One example of a market inefficiency is that in many emerging markets, reliable data is scarce and hard to access. For instance, sometimes data is difficult to access and only local investors can use it. If an investor is able to easily incorporate this data into their analysis, they may be able to act on an event that isn't apparent to other investors for days or even weeks, giving them an edge.
Case Study: Developed Markets
Another case of market inefficiency takes place in developed markets, which many investors believe to be very efficient. Each day, hundreds of analyst reports about the economy, its sectors and specific companies are published. In any given industry, it could take an investor a week to read all of the reports released in a day, leading to many reports going unread. However, if an investor builds a computer program to read and consume a report in a matter of seconds, they could put together a picture of an industry's or company's wellbeing that other investors do not see. This would allow an investor to act on information that other investors are not aware of yet, putting them out ahead of the market.
Long/Short Investing Allows for More Ways to Take Advantage of Market Inefficiencies
Traditional long investing, or buying stocks and holding them for a period of time, can be a way of benefitting from stocks increasing in value, but does not help an investor if they think a stock is going to fall. By not being able to profit from stocks they think will lose value, an investor is not able to make the most of market inefficiencies. Short selling, or selling borrowed stock with the intention of buying it back at a lower price at a later date, gives an investor the ability to profit from this insight also. Bringing together both of these investment techniques to create a long/short strategy allows an investor to generate returns from inefficiencies that cause stock prices to go up as well as down.
Market Volatility can be Mitigated Through a Long/Short Strategy
A long/short strategy can help an investor mitigate market volatility. By adjusting the proportion of long and short positions in a portfolio, the investor can control their exposure to the broad market. This makes the portfolio's returns less dependent on market trends, with the portfolio relying more on the investor's skill in picking the right stocks to long and short. If successful, a long/short strategy not only gives an investor more ways to profit from market inefficiencies, but can help them manage their portfolio's volatility.
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Incorporating alternative investments into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.
Investing in alternative strategies such as a long/short strategy, presents the opportunity for losses which exceed the principal amount invested. There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.
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