3 Reasons We Can't Exploit Pricing Errors in the Stock Market

The stock market contains pricing errors. And at first glance, it may seem surprising that I am saying that. Because, as I often explain, the stock market is efficient. But these two facts are not mutually exclusive.

But that is more of a theoretical and academic discussion.

We care more about practical terms. Meaning, how do these facts impact how we do and should invest our money to achieve the greatest, persistent returns that we can. So that we achieve financial freedom and can work and practice medicine because we want to, not because we have to.

And I will hold the suspense, myriad research supports the fact that we should invest passively via broadly diversified, low cost index funds. Because index fund investing outperforms active investing strategies all day long.

But active investing strategies seek to take advantage of pricing errors in the stock market. And I just said above that these pricing errors do in fact exist.

So, it begs the question, why the heck can’t we exploit these pricing errors to achieve greater returns – or alpha – in the stock market via active investing strategies?

Let’s look at some evidence first…

Does theory translate into practice?

As a matter of quick introduction, the identification of pricing errors in the market became a hot topic with the rising popularity of behavioral finance. And behavioral finance is basically the study of human behavior that leads to investment errors including the mispricing of stocks.

Richard Thaler, a professor at the University of Chicago, is one of the leaders in this field. And he’s very smart. And has provided some compelling evidence for the existence of such pricing errors.

But again, we need to ask if behavioral finance theory really translates into better returns in the stock market?

The short answer is no.

In one study looking at 16 behavioral mutual funds, authors found that:

The funds did perform the S&P 500
However this could be explained by their tilt towards value stocks
Once adjusting for risk, they did not outperform their benchmark persistently

In conclusion, behavioral investing was akin to value investing.

But what about the real experts?

Thaler himself created funds, called the Undiscovered Managers Behavioral Growth and Value funds, to exploit these errors in search of greater return on investment

In his book, The Quest for Alpha, Larry Swedroe compares these behavioral funds to two appropriate benchmarks: the DFA small cap and the DFA small value funds.

The findings: the combined return of the DFA funds was 7.4% over 2000-2009. And the Thaller funds? A combined return of 2.9% over the same time period.

It is very hard to argue that anyone can exploit pricing errors in the stock market to achieve higher gains.

But it’s all just so frustrating!

It’s almost analogous to observing a height discrepancy between two basketball teams but then finding that the taller team couldn’t exploit this to their advantage.

There are pricing errors in the stock market. But the stock market remains efficient.

So why can’t we exploit these errors!

Let’s take a look…

3 reasons we can’t exploit pricing errors in the stock market

These reasons remind me of Occam’s razor. Because they are very simple. But powerful. And in their simplicity, they seem to become more convincing.

1. A thought costs nothing, but an action does

When we study the stock market, we can find pricing errors. They are right in front of us.

But when we adjust our portfolio to exploit these pricing errors, something happens. We incur a transaction fee, or some other kind of fee. If we are investing in a taxable account, we also incur some type of capital gains tax – depending on how long we have held the sold asset in our account.

And, as it turns out, the cost of the trade generally will exceed any pricing error that was present.

So, the net effect is that your return is equal to or less than if you had never taken the reasonable action to begin with.

But why is that pricing error always so small? This brings us to the second reason…

2. Market homeostasis

The stock market is almost like a living, breathing thing.

When there are pricing errors in the stock market, someone discovers it. And they act to exploit it for greater returns. But that action does not happen in a vacuum. Others do the same, until the initial pricing error is eliminated or reduced.

It’s like a tree falling in the woods with no one around to hear it…

But why can’t we hear it? And this brings us to reason #3…

3. The market is just too big

If the entire stock market was just me against you, you could win. It’s like tennis, when I make an unforced error, you take advantage of it and put me away.

And even if the market consisted of only hundreds or even thousands of investors, some investors that acted right away may be able to occasionally garner greater returns from a pricing error.

But the stock market is billions of moving pieces happening in uber complex arrangements every second. And the biggest pieces are not even individual investors like you and me, but rather institutional brokerages.

The net effect here is that any pricing error is so quickly eliminated as market homeostasis is re-established that it effectively never existed to begin with.

Here’s a great analogy

I’m really leaning into the analogies here. And credit to Swedroe for this one.

Back to tennis. In his heyday, Roger Federer was the best tennis player. But he wasn’t the best in all aspects. Andy Reddick had a better serve. Nadal had a better backhand. But all together, Federer was the best. So, in a 1 v. 1 tennis match, he won more often than not.

(Even if you don’t agree with the player assessments, stick with me here.)

And the mistake investors make is we equate investing in the stock market to a 1 v. 1 tennis match. Us versus another investor. Because that is what we know, whether the analogy be tennis, chess, a medical procedure, or anything else.

The problem though, is that investing is not us versus another investor. Or one investment manager versus another. It’s us versus the entire market. It’s Roger Federer versus Roddick’s serve, Nadal’s backhand, and every other best attribute from other players.

And not even Federer can win that match!

The market consists of all of us. Individual investors. Wall Street. Professionals. The guy who did the whole Game Stop thing. And we all have the Internet. And all of the insane amount of information on the stock market and even other investment that exists via sites like Morningstar. Plus every person with a cell phone (AKA all of us) have instantaneous and immediate access to this information.

So, it turns out, just like Federer, even the best of us will lose that match against the market.

Let’s tie it all together

Pricing errors do likely exist in the stock market.

And that sounds exciting at first. It even gives credence to the idea that active investing can generate persistently higher than expected returns (alpha). It just makes sense. In just about every aspect of our lives, errors can be exploited for gain.

But the stock market is different.

Because there are costs associated with exploiting these errors. And these costs outweigh the gains from exploiting the market.

And the reason the costs outweigh the gains is because the stock market is efficient. Efficient because any effort to exploit errors inherently eliminates the error. And because we are investing against the entire market and all of the cumulative and instant information that it reflects at any moment.

What are we to do?

There is some good news here.

Investing gets a whole lot simpler once you accept the notion that you can’t successfully and persistently exploit any pricing errors in the stock market.

Once you accept this, the only logical approach is to invest according to your chosen asset allocation in broadly diversified passive index funds. And then do nothing other than rebalance yearly. And this logical approach is supported by the research and data.

Do this with at least 20% of your gross income. These are the main tenants of the formula to reach financial freedom!

Interested in more about how the stock market works? Check out these posts:

I also encourage you to check out Our Complete, Updated 2024 Written Financial Plan!

What do you think? Are there pricing errors in the stock market? Are they exploitable? Have you tried? Why or why not? Let me know in the comments below!