Efficient market theory

The valuation of stocks II.

Efficient market theory

The writer, a longtime author of books on financial topics, offers his view of the efficient market theory. The subject is hotly debated by supporters and critics and in recent years has come under increasing scrutiny.

The efficient market theory, or EMT also called the efficient market hypothesisis a comforting idea to many people who seek order.

But the truth is that the market is chaotic, irrational and, at times, downright inefficient. The EMT is a belief that markets are efficient because the prices of stocks have been adjusted for all known information and that price changes instantly as the information is updated.

This is a fatalistic belief, one that strives for a perfect and orderly world while warning that you cannot beat the market.

The truth, as most experienced investors know, is just the opposite. Markets are highly irrational and the predominant emotions — greed and fear — work to drive prices up too high on good news and too low on bad news.

Efficient market theory

This is why you often see prices spike only to correct in the sessions immediately following. A good example was the Oct.

The market overreacted to the positive earnings news accompanied by a revised full-year earnings estimate. But the next day, the market collectively reconsidered its enthusiasm and sold off the stock. This two-day swing in activity is far from efficient and, in fact, is illogical and chaotic in the extreme.

The net effect makes even less sense.

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All this market action is short-term, of course, but it aptly demonstrates why the efficient market theory is believed primarily by academics who have no money invested in the market.

In the s, he wrote his Ph.

Efficient market theory

According to the EMT, the opposite should be true. Like the related random-walk theory, which claims price movement is entirely random, the EMT falls apart under long-term analysis. EMT bases this conclusion on the belief that all prices are fair based on known data; and the random-walk theory claims that price movement is simply arbitrary and the outcome of upward or downward movement is a proposition.

Fama expanded his original theory by defining three forms of market efficiency: Even so, the distinction was a way to explain why apparent inefficiencies were experienced at times.

Many analysts have criticized this belief, however. Experience shows, in fact, that fast response often is the most inefficient form of price movement. The October volatility in IBM stock is an excellent example of this.

But they use rationale to explain irrational behavior in the market. For example, everyone knows that individual investors tend to overreact or underreact to news. EMT supporters believe these tendencies offset one another, so that the result is still efficient. As a result, the overall market reacts efficiently.

A more reasonable belief is that people in the market tend to move with the majority. The buying volume tends to reach a peak as prices top, meaning more people buy at the high than at the low. The same happens when the majority panics. Prices are driven down so that most sellers take action at the bottom.

This creates a tendency to buy high and sell low instead of the wiser opposite action. The inefficiency of the markets often is caused by the inefficiency of investors and traders.

The desire for efficiency is understandable and even works well in theory. But the real market is much more chaotic. Efficiency and Bubbles If markets were truly efficient, they should never have price bubbles.

Inwhen prices tumbled, many well-managed companies lost value in their stock because of fear and panic. There was no efficiency in the bubble or in the resulting selloff.

Even so, the many obvious bargain stocks remained low because everyone was afraid. How low would the market go? Stock prices would have fallen only for those equities that were overpriced and not in the entire market. Then again, there would never be any overpriced stocks in an efficient market, so even that belief is flawed.

Efficient markets can exist only if every investor is also efficient in how they think and act.Devotees of index investing also tend to be strong proponents of the Efficient Market Hypothesis.

There are a number of variants of the theory, but the basic idea behind it is this: the market effectively prices in all information that is realistic. Nov 01,  · However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in , suggests that at any given time, prices fully reflect all .

• Market Efficiency – An efficient market is a market that provides fair return to its investors. This is possible only when the market is able to quickly and accurately reflect the expectations of investors in share prices, this is known as market efficiency. Jan 12,  · by Jason Van Bergen.

An important debate among stock market investors is whether the market is efficient - that is, whether it reflects all the information made available to market . Historical background. The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his dissertation, "The Theory of Speculation".

[4] His work was largely ignored until the s; however beginning in the 30s scattered, independent work corroborated his thesis. The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices.

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