I was about 15 in the picture below, and skateboarding was my world. I don’t only mean that in the loose, figurative sense — everything in my world was filtered through the lens of skateboarding. My selective focus, or Reticular Activating System (RAS) made sure that I noticed every set of stairs, handrail, ledge, even the texture of the floor — all strictly through the lens of “Can I skate it?”. A rainy day didn’t count as a ‘real day’ because it meant no skating. Skateboarding even bled into my temporal perspective, and I gauged every activity as a direct trade-off against time spent skateboarding.
But now — after more than 10 years off the skateboard, I don’t see any of the things that I used to see anymore. A set of stairs is simply a chore to climb. A ledge is a place to sit with my cup of coffee. A handrail is ambulatory support. The texture of the floor is almost irrelevant. I’ve even learned to enjoy some rainy days.
I now live in a different world. I value everything on a different standard. The objective world has not changed, but only my subjective focus. My focus determines what I see and what I don’t see, and that determines my reality.
What does this have to do with real estate and investing? Nothing — and everything.
The Canon of the Efficient Market Hypothesis Vs. Skeptics
The equities investment world can be divided into two theoretical models — efficient vs. inefficient market hypotheses.
Proponents of the efficient market hypothesis say that the current price of the stock is a true indicator of its fair market value and that it fully reflects all available information. Therefore it’s not possible for an individual investor to ‘beat the market’, and that the best course of action is to ‘ride the market’ instead through purchasing ETFs or index funds.
Skeptics of EMH say that the price does not reflect all available information, and that stocks can be undervalued or overvalued due to fear, inflated expectations, systemic inefficiencies and various cognitive biases. Investors who can recognise such instances can profit by purchasing undervalued stocks.
So which is true? Paradoxically, both are.
I mentioned the Reticular Activating System (RAS) earlier. Whether you believe the market to be efficient or inefficient, your selective focus (RAS) will find confirmation of your beliefs and turn a blind eye to any evidence that contradicts it. So whatever you believe will become true, in your own subjective reality.
If you believe in strong market efficiency, every data point you observe will confirm that it is virtually impossible to beat the market consistently. Every ‘win’ will be attributed to chance, something that will inevitably be counterbalanced by an equal ‘loss’. If you believe in market inefficiency, you will become a student of the market and the underlying dynamics of the intrinsic value of a stock. You’ll look for instances of undervaluation, and probably find them.
But ending the discussion there will not be very productive. RAS is exactly the reason why people rarely change their opinions on anything. So instead, let’s suspend our clinging to subjective realities and apply logic and first principles thinking.
The premises:
- The ‘market’ is simply an aggregation of buyers and sellers
- As such, any underlying traits of individual buyers and sellers are reflected in the broader market
- For the market to be fully efficient, actors must know all of the information as it relates to the transaction and;
- Act logically and rationally in accordance with the known information
Nothing groundbreaking here. But by constantly calling the market ‘the market’, there is a tendency to think of it as some external entity with its own will, tendencies, and even moral or supernatural judgement. Even Benjamin Graham personifies the market as “Mr. Market”. Although this can be helpful to understand certain concepts at times, I think it’s better to recognise it for what it is at the core — a congregation of buyers and sellers.
So, to determine whether the market is efficient or not, we simply need to find out whether individual buyers and sellers make efficient choices or not.
Can you build a yellow brick wall using only red bricks?
We don’t need to look very far to discover that individual decisions are not efficient. IMHO — not even close.
I’m a real estate investor, not an equities investor. But for the sake of citing some anecdotal evidence, from the few occasions that I did trade in the stock market, I can definitely admit that my decision was not made to reflect all available information (actually, it would’ve been near impossible for me to digest, understand and apply all available information. By the time I would’ve been done consuming the info, the market would have moved on). Undoubtedly, there was also a good dose of emotion and wishful bias involved in my buying and selling.
There is also strong empirical and academic evidence points in the same direction, a couple of which I’ll list at the bottom of this article for the sake of brevity. Notably, the occurrences of extraordinary market crashes or sudden bull streaks point to the case that often the price of the stock can be quite removed from its fair market value.
Evidently, the operating system, or the base psychology of a human being, is inseparable from emotions. So if transactions are inevitably inefficient at the individual level, how could the market as a whole be efficient?
Can you build a yellow brick wall using only red bricks?
Market Inefficiency in Real Estate
In real estate, there is no central exchange where pieces of property ownership are bought and sold by the second. Most property transactions are retail and individual, which means that the final transaction price is often influenced by urgency, emotion and other personal reasons. Additionally, unlike the stock market, buyers of properties have a direct line of communication with the seller, making it possible to establish terms and prices that are materially different from the intrinsic value the property would achieve on the open market under normal circumstances. This market inefficiency gives the enterprising property investor clear opportunities to purchase properties that are undervalued and beat market returns.
Your Call
The world that I saw as a 15 year old is not the world that I now see. Where I used to see a set of stairs as an opportunity to kick down, I now see an opportunity to increase space efficiency and ROI. What opportunities you do or don’t see are determined by your world view. Do you live in an efficient or an inefficient world?
The efficient world is deterministic. More predictable. Less profitable.
The inefficient world is enterprising. More chaotic. More profitable.
I’ll leave it to you to decide. For now, I gotta go and dust off my old skateboard and hope I still remember how to kickflip.
Stay epic,
Sam Lee
References
Lessons from Thinking Fast and Slow
The enduring impact of transient emotions on decision making