Investments

Explain What The Efficient Market Hypothesis Means To Investors

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

When you hear or read news about a prominent corporation like Apple or Google, how frequently do you feel prompted to make a move in the stock market? To what extent is it too late to invest in a firm with potential once a story about it has made headlines?

The assumption that stock prices accurately reflect news and information has been the subject of heated discussion amongst financial experts for years. Before making any investments, especially in response to business news, you should familiarize yourself with the hypothesis.

The Efficient Market Hypothesis’ Laws

Regular stock purchases and sales help keep the wheels turning in the securities markets. It is difficult to exploit information to benefit in a market, according to the efficient market hypothesis, because the market must reach an equilibrium point based on those transactions. 

Fundamentally, by the time you learn about something in the news, it is already too late to capitalize on it in the market. However, not everyone believes that the market always acts efficiently.

There are now three main schools of thought on the efficient market theory, and all three have substantial evidence in their favor.

  1. If a stock has a weak form, it means that the current price already incorporates all of the stock’s historical market data. Technical analysis is useless for predicting the future of a stock because it only looks at price trends in the past.
  2. The semistrong form indicates that the stock price completely reflects all publicly available information. When evaluating an investment, it is useless to focus on recent events or the most recent financial results.
  3. The stock price is a true reflection of all available information, according to the strong form. The value of insider knowledge is negligible at best when prospecting.

The Argumentation for these Arguments

Expert investigations test and validate the efficacy of such speculations. Both sides of the argument will likely be heard, suggesting that markets are probably neither totally efficient nor inefficient. If you’re a private investor, knowing how quickly markets absorb and react to news is crucial.

There are exceptions to the efficient market hypothesis. During the course of their investigations, researchers uncovered some outliers that cast doubt on the generalizations. 

The gaps in the theory represent investment opportunities:

  1. There is a correlation between a stock’s performance and its price-to-earnings (P/E) or price-to-sales (P/S) ratio.
  2. Analysts often make erroneous predictions about the value of foreign stocks.
  3. Smaller businesses, despite being inherently riskier, typically outperform the market.
  4. Commonly, IPOs fail to match the market’s performance.
  5. When insiders buy or sell shares, it’s usually a hint that the price of the underlying security is about to change dramatically.
  6. In some cases, such as when moving averages or trading ranges are broken, using historical market data can assist you to forecast the price of an asset in the future.

Efficiency varies from market to market. Generally speaking, experts agree that government bonds are the most efficient market, with large-cap equities coming in a close second. Real estate and other assets are less efficient since not all participants have the same level of expertise and data.

Criticism of the Efficient Market Hypothesis

However, most industry experts, including those who believe in the efficient market theory, acknowledge that some asset classes are riskier investments than others and, as a result, can produce larger returns. 

You need to strike a balance between the potential benefits and losses of your investments. You might feel more at ease after hearing the two sides of the debate between professionals.

When Burton Malkiel published A Random Walk Down Wall Street in 1973, he was a staunch advocate of the efficient market hypothesis. 

He claimed that a chimpanzee wearing a blindfold could toss darts at the Wall Street Journal and pick assets that would perform as well as those picked by professionals. He recommended low-interest, market-cap-weighted index funds as an investment option.

My finance professor, Richard Spurgin, is well-regarded as an industry expert. Although he accepted the efficient market idea, he did discuss several peculiarities in the market. 

After graduating, he entered the workforce as a technical analyst, a role in which he attempted to forecast the performance of securities by analyzing their past performance. An efficient market proponent, he yet recognized the potential for gain from such tactics under certain conditions.

When I graduated from business school, I realized that the potential for massive profits from stock market investment wasn’t as huge as I had assumed it would be. My goal of one day succeeding like Warren Buffett is already a distant memory. 

Although there has been heated argument on both sides of this issue, I believe there is sufficient evidence to support the efficient market hypothesis, and that the only way to outperform the market is to take higher risks.

Even while some investment portfolios might exceed the market in a particular year, this does not indicate that markets are not efficient. Extraordinary portfolios routinely outperform the market. 

So few investors have achieved the sustained success that I am now certain the efficient market hypothesis is at least partially true. Amazing as it is to see a portfolio return 30% in a single year, the very same portfolio, since it is risky, will likely lose all of its gains in the next year.

Bottom Line

The advice of Malkiel is being followed by me. Rather than putting all of your eggs in one basket, it’s best to spread them out and take calculated risks with a diversified portfolio of assets and stock investments. 

Don’t get too confident in your ability to invest, but don’t let it stop you from thinking critically about security. In the same way that the vast majority of professional money managers fail to beat the market, your chances of success are low.

To the extent you believe the efficient market hypothesis is true is a matter of personal preference. Possibly, you believe you can achieve success by competing in this market. But you should still check the evidence and broaden your horizons. 

Putting all of your eggs in one basket is risky business, and you should spread your money around. Keep in mind that it takes more than just one news article to get the full picture. 

Use the top financial news and analysis websites to do an in-depth study on the stock market. There are a lot of factors to consider in order to predict the future of an asset in the securities market.

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