September 07, 2016

The Imperfect Market

When concerned with investing, the ‘perfect market’ assumption urges us to question, what is it that a stock’s price is indicating? Such inquiry can provide greater insight as to the influences on price. On some occasions the price is telling you that in fact, the market may not be perfect. True investment analysis digs deeper into any decision than simply price-determined factors.

This notion of a perfect market argues that there is accurate data informing the price of a stock. However, often changes or fluctuations in price are an indication of something outside the influence of, or unexplained by, a perfect market. In some cases, it may indeed be an inaccurate assumption to claim we are operating in a perfect market environment, and this should not necessarily be presumed in comparison with the fundamental evaluation of a stock.

The financial crisis led banks to remove margin lending on many stocks, due in part to their volatility. There is a fundamental difference, however, between volatility and risk. There is a certain irony in the fact that, at a time when prices were not only cheap but also offered the best value, banks withdrew the option to lend against such stocks. Then, as the price rose, banks reinstated lending on these stocks. The lesson here is that higher risk does not necessarily lead to greater returns, and seemingly, low risk does not always lead to safer return.

Portfolios comprising blue chip stocks, with a history of stability and lack of volatility in price, do not necessarily entail less inherent risk. It may very well indicate an imperfect market scenario, where overcrowding in particular categories in the market inflates the price of certain stocks beyond their true worth. What the price is indicating in these instances, is that the market is indeed not perfect.

More than one market phenomenon may be in play, and with varying implications on overall performance. A more prudent approach may be in scrutiny of the underlying business, rather than the price, which fluctuates often at the whim of the most recent media headline. Clearly, whilst caution is necessary, so is further insight.

A company with good fundamentals, but whose price has deviated from this on account of other short-term market trends or influences, may represent an opportunity to capture its underestimated value, and demonstrates the virtue in forming a well-rounded and objective view when investing. Ultimately in the process of making investment decisions, we must pay respect to the commonly accepted market assumptions, and the natural momentum of price. However, recognising the presence of imperfect market characteristics may indeed lead to a clearer judgement of a stock’s true value, as upheld by fundamental analysis.