As the director of research for The BAM Alliance, and the author and co-author of 15 investment books, I’m often asked about other books I would recommend. For serious investors who want to gain a deeper understanding of how markets work and the strategies most likely to allow them to achieve their financial goals, my short list of “must-read” books (in alphabetical order by author) has been:
- “Expected Returns” by Antti Ilmanen
- “Successful Investing Is a Process” by Jacques Lussier
- “The Success Equation” by Michael Mauboussin
- “The Physics of Wall Street” by James Weatherall
I’m now adding Lasse Pedersen’s “Efficiently Inefficient” to that group. The book clearly is written for professionals and experienced investors who have taken a serious interest in what might be called “the science of investing,” or evidenced-based investing.
Regarding the book’s title, Pedersen explains: “Markets cannot be perfectly efficient and always reflect all information. If they were perfect, no one would have any incentive to collect information and trade on it, and then how could markets become efficient in the first place? Markets also cannot be so inefficient that making money is very easy because, in that case, hedge funds and other active investors would have an incentive to trade more and more.”
His conclusion is that “the information contained in market prices must be efficiently inefficient, reflecting enough information to make it difficult to make money, but not so efficient that on one wants to collect information and trade on it.”
Later in the book, Pedersen writes: “The efficiently inefficient equity market has the property that prices can wander further from their fundamental values for illiquid stocks that are expensive to trade, volatile stocks that are risky to trade, stocks with large supply/demand imbalances, and stocks that are costly to short-sell, especially when active investors are facing reductions in capital and financing opportunities.”
Of course, this type of scenario presents an opportunity for certain investors (like Warren Buffett) who have the capacity and stock to accept such risks in bad times. That is why Buffett, who warns against trying to time markets, recommends resisting the temptation to be a seller when others are panicking and to be a buyer when others are greedy.
What Works, What Doesn’t
Pedersen compares and assesses the intelligent and systematic investment approaches likely to produce the best long-run performance. He does so by describing and analyzing the key trading strategies (including many “hedge fund” strategies, such as convertible arbitrage) used by some of the market’s most successful money managers.
In addition, he presents the evidence and logic—including both risk-based and behavioral-based explanations—for the success of each strategy he explores, and walks the reader through real-world examples.
While the first part of Pedersen’s book focuses on active investment strategies, such as those deployed by hedge funds, it contains advice valuable to every investor.
For example, the chapter on portfolio construction includes a list of key general principles employed by the most successful investors. Besides advising some of the largest companies in the world on managing financial risks, Pedersen has run trading rooms for two large financial institutions and advised individual as well as institutional investors for the past 20 years.
Given his wide experience, I believe his list should be framed and kept as a permanent reminder for all investors.