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Market Inefficiency

Definition


A market is said to be inefficient when it provides consistent opportunities for profits.

Examples


  • When an asset is trading at different prices on 2 exchanges, that is a market inefficiency.
  • When you are able to use satellite images of corn market to predict future harvests, that is a market inefficiency.
  • When you can find order patterns to tell when a bank needs to buy an unusually large amount of Apple stocks today, that is a market inefficiency.

Description


Difference between Market Inefficiencies and Luck

In a game of blackjack, making money in one hand does not mean you have found a consistent way to make money. You might lose more in the next 3 hands.

Similarly, making money off one trade does not mean you have found a market inefficiency.

Checking for Market Inefficiency

There are 2 ways to check if you have found a market inefficiency.

Method 1) Break it down to first principles

This means to question your decision until you reach the base rationale/assumption.

Our aim is to find a clear cause and effect.

If X happens, Y should happen. If Y doesn’t happen, we do Z to profit.

Method 2) Make consistent profits

When you cannot identify a clear cause and effect because there is too much uncertainty, use consistent good performances as an indication of market inefficiencies.

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