The Efficient Market Hypothesis
While the title may sound esoteric, it’s really quite simple and pragmatic.
At its core, the Efficient Market Hypothesis states:
- Free and open markets, such as the stock exchanges,
incorporate all available information almost instantly;
- Security prices follow a random walk model.
So what can the investor do?
Through various products available from a number of companies, the investor can invest in markets as a whole and thus ride the sum knowledge of all investors. Empirical evidence has repeatedly and consistently shown that broad-based market indices (passive investing) outperform the stock pickers (active investing) when risk is taken into account and adequate time is given.
Eugene Fama developed the Efficient Market Hypothesis in his doctoral dissertation for a PhD in economics at The University of Chicago in the 1960s. Since then, to the chagrin of stock analysts around the world, the Efficient Market Hypothesis has held up to repeated challenges from those whose business it attacks, namely, the Wall Street brokerage firms and most financial advisors/stock brokers/insurance salesmen. The validity of the Efficient Market Hypothesis is widely known and Fama was awarded the Nobel Prize in Economics for it in December 2015.
With this in mind, the next logical question is: “What can an investor do if the market has already incorporated all information and price movements are random?” Fortunately, the investor has a number of things he can do to better develop and pursue his investment goals.
The application of this is straight forward. In short, the investor can ignore the pundits on television and everywhere else who are saying things like: “IBM is priced at $45 a share and it’s really worth $53 a share”, or “The market will rally to 20,000 before the end of the year”.
For example, regarding the $53 a share for IBM when it’s currently priced at $45, the market has already incorporated all of the buyers and sellers of IBM stock and the settled upon price, which has all available information reflected in it, is $45. Further, no one is clairvoyant and price movements are random. Over the long term, as capitalism moves forward and viable companies grow, stock prices will increase. But at the moment, the price reflects what the company is worth on the open market. Studies have repeatedly proven that stock analysts don’t systematically, predictably, “beat the market”.
To be sure, just as someone wins at slots every day in Las Vegas, some analysts will beat the market. However, as the time horizon lengthens from days to weeks to months to years, the number of stock pickers who beat the market decreases precipitously. Further, no one knows, a priori, before the fact, who will beat the market.
Chapter 1 of Great Minds. Great Wealth. Great for Your 401k. goes into the efficient market hypothesis, as well as its implications and applications, in detail.