On the (In)Efficient Market

A Screenplay in Two Acts by B.Sc. Dominik M. Roth

Act I: The Efficient Market

Lights. Curtains. The Efficient Market enters the stage from the left.

Efficient Market:

We generally assume the market is efficient. Any asset is priced based on its potential to provide future returns. When an asset is underpriced, smart investors buy it, bringing the price to a fair level. In a perfectly efficient market, opportunities to outperform the market don’t exist. While the real market isn’t perfectly efficient, it’s close enough that inefficiencies are minimal. Any “smart” investment strategy is likely nonsense, and get-rich-quick schemes are certainly so.

No reliable signals of future performance exist in an efficient market. If such a signal were discovered, traders would quickly exploit it, causing the predicted price movement to happen immediately. The signal would then stop being useful, as the market would have already adjusted.

When your gut tells you of a coming market correction, it’s best to ignore it—unless you have reason to believe your gut is smarter than most financial experts. When media outlets predict a recession, it’s best to ignore them. If they truly knew, they’d trade on that knowledge and get rich, not share it for free. Time in the market beats timing the market.

In an efficient market, the specific details of any asset can be ignored because the price already reflects all known information. Assets can be reduced to two components: a long-term upward trend and short-term noise that causes fluctuations referred to as volatility or risk.

When choosing between investing in a single asset or multiple assets with equal performance and volatility, diversification should always be preferred. The expected return is the same, but the combined volatility decreases, assuming the price movements aren’t perfectly correlated. Diversification is the only “free lunch” in investing; any strategy that reduces diversification increases risk without improving returns, making it a net negative.

While I mentioned reducing assets to two variables, they are actually related. In 1990, Harry Markowitz won the Nobel Prize in Economics for showing that modeling investors as rational agents, acting based on a convex utility function, allows deriving a concrete mathematical model between volatility and performance: More volatility means higher returns. This applies to individual assets, not portfolios. Therefore, reducing volatility through diversification remains a free lunch.

The perfect guide for investing in an efficient market is simple: Understand your wealth, decide on your desired monthly withdrawal rate, and determine how much you’re willing to reduce this rate during recessions. Recessions happen and can’t be predicted in advance. How far the market dips and how long it takes to recover can only be estimated from past recessions. If you want a stable withdrawal rate, choose a low-volatility portfolio. If you can tolerate fluctuations, a higher volatility target can yield better returns. The expected return of any portfolio is just the risk-free rate plus a risk premium derived from the volatility.

Construct the perfect portfolio by maximizing diversification across asset types that align with your target volatility. This is generally done with a mix of globally diversified stocks (performing at about 10% per year, 7% after inflation) and lower-risk bonds and commodities (just barely beating inflation). Instead of investing a large sum of money all at once and risking accidentally hitting a point in time just before a downturn, investments should be spread out over time, which is referred to as “dollar-cost averaging.”

Managing such a portfolio should be cost-efficient, with options like the Scalable Capital Wealth World Portfolio Classic (https://de.scalable.capital/en/world-portfolio-classic) . Investment products costing more than 1% per year or which have additional costs during investment and withdrawal are likely too expensive and should be avoided.

Most people don’t invest this way. The reason might be that it seems too simple. Money is important, and people believe the answer to how best to grow it should be complex. They prefer elaborate strategies, even though these often lead to reduced returns or increased risk. Complex investment strategies also tend to be more profitable for those selling you the assets. Almost all actively managed portfolios perform worse than a passive, maximally diversified portfolio. The truth is that failing to maximize diversification only diminishes expected returns or increases volatility with no benefit.

Act II: Market Inefficiencies

The Inefficient Market enters the stage from the right, walks up to the Efficient Market, and punches him in the face. The Efficient Market tumbles and falls off the stage to the left.

Inefficient Market:

First: in a truly efficient market, bubbles cannot exist. If prices always reflect all available information, a collective delusion about value is impossible by definition. So let’s talk about what has actually happened.

US railroad mania, 1860s to 1880s. The federal government handed out land grants on a scale that staggers the imagination, and capital poured into railroad construction far beyond what traffic could ever justify. When Jay Cooke and Company collapsed in 1873, it triggered a banking panic and a depression that lasted six years. The technology was real. The valuations were not.

Japan, 1989. The Nikkei hit 38,915. Tokyo’s Imperial Palace grounds were estimated to be worth more than all real estate in California. Price-to-earnings ratios on the index exceeded 60. When it collapsed, Japan entered a deflationary spiral it spent thirty years trying to escape. The Nikkei did not recover its 1989 peak until 2024.

The dot-com bubble, 1995 to 2000. Companies with no revenue and names ending in .com traded at extraordinary multiples. Pets.com raised $82.5 million in an IPO and was liquidated nine months later. The NASDAQ lost 78% from peak to trough. And yet the underlying thesis – that the internet would restructure the global economy – was correct. The market got the direction right and the timing and valuation catastrophically wrong.

The housing bubble, 2005 to 2008. Mortgage-backed securities were rated AAA by agencies that did not understand what they were rating, sold to institutions that did not understand what they were buying, insured by companies that did not understand what they were insuring. The model said house prices did not fall nationally. They had not. They did. The resulting crisis wiped out trillions in wealth and destabilised the global financial system.

These are not edge cases. They are some of the largest capital markets events in history, all occurring in mature, liquid, heavily-analysed markets. The efficient market hypothesis has no satisfying account of any of them.

Now consider Tesla from 2019 to late 2021. One of the most traded stocks on the planet, covered by hundreds of analysts, massively shorted for years. And yet the stock rose approximately 1,500%, from around $35 (split-adjusted) to over $400. Someone was wrong for a very long time. The market eventually came around; the early investors who saw the manufacturing scalability, the data flywheel, and the autonomous driving thesis before consensus did were simply right. And the markets are currently still not rationally valuing Tesla. Tesla is probably on the verge of solving autonomous driving, and no other company is even remotely close.

Tesla’s approach is both scalable and cost-effective. Competitors such as Waymo are heavily dependent on high-definition maps and human annotation, making them expensive and impossible to scale globally. Tesla’s FSD sees the world through cameras and solves driving generally, without needing HD maps or pre-mapped routes. Once FSD works in California, it’s only a small step to expand across the U.S. and then to the rest of the world. Waymo’s vehicles cost $500,000 to $1 million each. Tesla already has millions of cars on the road with the necessary hardware, and can activate FSD at no additional cost per vehicle, transforming them into revenue-generating robotaxis with Tesla taking a cut. The reduction in cost to operate at global scale is absurd.

Tesla’s next move is a fleet of robotaxis, with its global factories ready to scale production. This positions Tesla to dominate personal transport and, through the Tesla Semi, freight as well.

Tesla’s P/E is highly elevated. Yes, the market knows FSD is the thesis and has priced in some probability of it working. But pricing in a probability is not the same as pricing in the full consequence. The potential of autonomous driving at global scale is not fully described by the stock price. Not even close.

Or Tesla crashes to zero. Probably not, but who the fuck knows? Anyway, bye…

The Inefficient Market pulls a microphone from his pocket and drops it on the floor. Curtains close.