Some would argue that this inefficiency is the main reason why the market works. This is because when people buy financial assets, they do so because of their own reasons.
When they do this, there are people on the other side too to sell.
For markets to exist, there must be some sort of greed and other inefficiencies too.
It is for this reason why people are always eager to buy stocks and other useless products before even understanding their worth. It is known as fear of missing out.
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FOMO – Fear of Missing Out
The fear of missing out situation is not new. In fact, the fear has been there for centuries.
Hundreds of years ago, people from Netherlands were made to believe that the value of tulips would continue going up. Most of them borrowed money to buy the tulips.
Ultimately, when the quantity of the tulips increased, the people realized that they had no value.
Just in recent years, the value of cryptocurrencies increased as people from around the world continued to buy them.
Most of them bought things they did not understand because they believed their value could not drop.
In the 2018 alone, the value of the cryptocurrencies has declined by more than 80%.
Most of those who bought the currencies during the climb lost their money while the ‘smart money’ made money during the climb and the downward trend.
What Causes Market Inefficiency?
Identify the Bubble
The first thing you need to do when you want to make money during a bubble is to buy when the bubble is forming.
To know when it is forming, you need to do a simple thing.
Identify a relatively new asset. This could be a stock or an asset class like cryptocurrencies. As its price starts to rise, it generates a lot of talk in the market.
Everywhere you go, people will be talking about it. This is a clear indication of a bubble. You need to buy it when the prices are low and wait for it to rise.
As time goes by, the price continue to rise.
The Price Decline
After some time, the asset price starts to decline but the downward momentum is halted by news. At this stage, even little news bullish on the asset will lead to a price increase.
As the price starts to move up again, investors will continue to rise. However, this is not the ‘smart money’ that is buying. Instead, they are ordinary investors who don’t have a good understanding about the industry.
What follows is the price starts to decline as selling volumes increase.
Price Tanks
Ultimately, the price tanks. As a ‘smart trader’, you now need to take the opposite trade and short it.
There are a few rules in this.
#1. Only put very little amount of money to these risky assets. They should account for less than 10% of your funds.
#2. Always have a trailing stop loss that will help reduce your chances of losing money.
#3. Understand how volatile these assets are. In a given day, the value of an asset in a bubble can go up or down by more than 10%. Therefore, you need to be prepared about all this.
External Useful Resources
- Efficient Market Hypothesis: Is the Stock Market Efficient? – Investopedia
- ‘The Market Is Always Wrong’: In Defense Of Inefficiency – Forbes
