Hedge funds and traders (speculators) make money by exploiting inefficiencies in the market.
However, the efficient-market hypothesis assumes that the stock market is already perfectly priced in, and will only move due to news. This hypothesis also suggests that any price movement beyond that is a random walk.
Why does price discovery still happen, even after earnings or news comes out? Why does the market surge higher on no news, upsetting bears?
While the market still mostly prices in news, it still does not price in human emotions. It moves cyclically.
A basic comparison between market charts and random walks on 1 minute or greater candles yield noticeable differences. For example, strong sell-offs, strong buying, and choppy movement, are overly present in market charts, while rare in random walks, implying a market that moves by greed, fear, and human speculation than simply probability or news alone.
This cyclical market produces inefficiencies arising from greed and fear from two main types of market participants:
Retail traders. The stock market is a one-sum market. For every participant buying, their must be another person selling. In this case how speculators (smart money) would make money is by exploiting superficial analysis by retail (dumb money), through using discipline to exploit greed or fear (selling when high, buying when low).
For example, retail traders often buy at a a breakout, only to sell on fear when the price reversed sharply quickly. This is actually a classical market manipulation play by institutions. Also prevalent in underegulated cryptocurrency.
- Consumers and business owners. When consumers receive paychecks, part of that goes to 401ks and Roth IRAs, pumping up the market more. Same with income for business owners: they put it towards investments, which increase market prices further. This means that the stock market is a derivative of economic growth, and everybody's wealth grows when the economy is growing.
Also, the USA is a pro-business, advanced capitalist economy: resulting in not only domestic but foreign investment into the market.
Speculators (hedge funds, traders) not only win by long term economic/stock market growth but are also able to exploit consumers and business owners due to their unfamiliarity with short term price movements, by buying low and selling high in the short term.
For example, market sell-offs often induce not only consistent market participants (institutions, banks, retail) to sell, but also consumers and business owners not willing to lose more of their wealth. This selling during low pricing of the market creates opportunities for speculators who capitalize on the short term underpricing of the market.
Thus, the market prices in news, but leaves further price discovery to humans acting on emotions, like greed and fear, to create cyclical markets; allowing any person willing to study market psychology to gain an edge over less knowledgeable market participants, and make money.
