Investor Facts: What Is The Efficient Market Hypothesis?

Posted on February 24, 2020 at 12:25 PM PDT by

Stocks are priced by traders all day, every day that the markets are open. Presumably, at any given moment, the price set by those many trades is accurate by definition.

That is the efficient market hypothesis in a nutshell. The idea is simple: Unless you have inside information, which is illegal to trade on, then the public price of a given investment is correct. Markets are efficient.

While the academic argument for the efficient market hypothesis is strong, that doesn’t stop traders and investors from trying to find stocks that are undervalued to buy or overvalued to sell short.

Of course, all this frenzied activity in an attempt to find mispriced stock means that there is just more trading, the effect of which is more, not less, efficiency in price discovery.

Consider a gas station on a country road. It has gas priced at $2.75 a gallon. There are no other gas stations in sight, maybe for miles.

Is gas really $2.75 a gallon? It’s impossible to say, and if you need gas now that’s what you will pay.

On a busy city street corner there are four gas stations. Each of them is vying for business from the hundreds of cars and trucks rumbling by. So each station cuts prices by a few pennies on the half-hour, maybe more at rush hour.

Now you can be far more certain that whatever price is posted — let’s say it’s $2.25 a gallon — is going to be nearly the same at all four stations. You can be nearly as sure that the margin on each gallon sold is minimal. Each station is hoping to get your gas business at a loss or nearly so in order to sell you an overpriced cup of coffee and a doughnut while you pump.

Stock markets are like that urban gas station face-off, only multiplied dramatically. Many big brokerages now offer trades for free, so trading is fast becoming a loss leader to gather capital against competitors.

Market declines

That competition only heightens the efficiency of the markets and bolsters the academic view that efficient market hypothesis must be true. It’s also the reason why so many long-term investors have gone over to low-cost index funds that own the whole market instead of trying to trade in and out of any given stock.

So why do stocks sometimes fall dramatically, as happened in 2008, in 2000 and many times before? Were the markets inefficient in those moments?

Perhaps. Another explanation is that too many traders began to ignore their own tolerance for risk. Greed took over and prices began to reflect a wish more than an underlying reality.

When greed overtakes a large percentage of the market’s investors prices can be distorted and, by definition, they are now inefficient. Inevitably, that efficiency is reasserted and prices stabilize and recover.

A lot of money can be lost along the way, but for every panic seller there are buyers who take the long view that efficiency will inevitably return — just at a price far above the frightening lows struck in a market decline.

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