Efficient market theory, or hypothesis, holds that a security’s price reflects all relevant and known information about that asset. One upshot of this theory is that, on a risk-adjusted basis, you can’t consistently beat the market. The theory, which is controversial, has significant implications for investment strategy. Here is an overview of the theory that provides potential insights into how to invest.
What Is an Efficient Market?
At the heart of the theory is a view of how securities markets work. The theory maintains that market prices efficiently reflect an asset’s underlying value, including the company’s cash, hard assets, intangible assets and liabilities. For example, say Grow Co. released 1 million shares at $10 per share. In an efficient market, this would mean that Grow as a company is actually worth about $10 million when accounting for its total holdings, all of its debts and a realistic projection of its future growth. If shares fall to $8, traders will have an incentive to hold their shares or even buy more because the market will, sooner than later, efficiently reflect the stock’s actual value of $10.
This contrasts to the view that markets work inefficiently, meaning a security’s price reflects factors other than its underlying value. An inefficient market behaves more like a casino, with traders buying and selling stocks based more on how they think other traders will react than on any analysis of the asset itself. For example, if the market is inefficient, a jump in Grow shares to $20 would reflect traders buying the shares not because they believe Grow is fairly valued at $20 per share but because they believe other traders will pay $21 for it.
Inefficient markets tend to create bubbles. For example, if Grow shares decline to $18 from $20, a trader would be incentivized to sell. That’s because the shares had moved so far from their true value, the trader couldn’t anticipate either future gains or dividends to offset the share price they had paid. This creates incentives towards instability.
What Is Efficient Market Theory?
Efficient market theory holds that markets operate efficiently because at any given time, all publicly known information is factored into the price of any given asset. This means that an investor can’t get ahead of the market by trading on new information because every other trader is doing the same thing.
It’s important to note that efficient market theory doesn’t argue that the market will get things right at any specific moment. Markets can overvalue or undervalue an asset. It argues, instead, that the market will get things right over time. If an asset strays too far from its value, the market will eventually correct that mistake.
Three Forms of Efficient Market Theory
There are three main forms of efficient market theory:
- Strong – At any given time the market reflects absolutely all relevant information, public and private. While a trader might occasionally capture unusual gains, this is almost always because of short-term inefficiency. Over time, no investor can gain a consistent advantage over any other.
- Semi-Strong – The market reflects all publicly available data at any given time, including historic trading information and business fundamentals. However, a trader can get an advantage through private data or otherwise limited information. Note that any trader attempting to operate under the semi-strong theory would likely run afoul of insider trading restrictions in the United States.
- Weak – The market reflects all historic data for asset prices. Under this theory, no trader can capture gains from technical analysis because every trader has access to the same historic information and has priced this into their position. However, fundamental analysis and future predictions can help a trader get an advantage over time, as this information reflects an individual trader’s judgment rather than black-and-white data.
Application of Efficient Market Theory
For a retail investor, the most significant implication of efficient market theory is its argument that you cannot consistently beat the market. Whatever you know, every other trader already knows and has factored it into their position as well.
This is not to say that you can’t sometimes get things right. A given stock pick can succeed, but over time your position will not outperform anyone else’s. As a result this theory suggests that investors should put their money into assets such as index funds and keep them as part of a buy-and-hold strategy to capture overall market gains.
The Bottom Line
Efficient market theory says that no one can consistently beat the market. Whatever you know, the rest of the market knows it too and has already begun trading on that information. This means that every stock’s price already reflects all of the available information about the stock itself and its underlying company. That doesn’t mean you can’t ever beat the market; some traders do get lucky. Over time, though, your results will even out to no better than the market’s results as a whole. Proponents of this theory say it explains why so few money managers can consistently outperform major market indexes. Opponents of this theory say it defies the insights of behavioral economics.
Tips For Investing
- Consider talking to a financial advisor about efficient market theory and its implications for your investment strategy. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Once you understand efficiency, the next best thing to learn is risk management. While efficient market theory says that you can’t beat the market, there are riskier sectors and safer ones. Your personal appetite for risk can determine the kind of gains your portfolio makes, but also the kind of losses it has to endure. With modern portfolio theory you can start to maximize the efficiency and risk in your portfolio.
Photo credit: ©iStock.com/cokada, ©iStock.com/ogichobanov, ©iStock.com/baona