The Theory of Stock Market Efficiency

The goal of every stock market investor is to do better than the averages. According to the efficient market theory, you can't. The hypothesis suggests that stock prices reflect the average value that investors place on the stock. The idea is that there are so many investors analyzing a stock that it's very unlikely that any facts go undiscovered. That means you stand no chance of stocks that are underpriced, according to the theory.

Reliable Information

Information about stocks and companies in the United States is cheap and very reliable, according to the Library of Economics and Liberty. This is partly because publicly traded companies are required to disclose all financial information It is also the result of the Internet. Numerous sites post financial information and news about companies and their stocks. This means that on any given day, investors as a group know all the information about a stock and can determine what it is worth to them. Certainly, some investors dig deeper and have more information than others. But according to the efficient market theory, the average of all investors' buy and sell decisions result in a stock price that has all the information factored into it.

Buy vs. Sell Orders

Efficient market theory does not state that investors agree on the price. In fact, it is their disagreement that makes the market efficient. Many will see a stock as a good buy, and those who disagree will be glad to sell them their shares. Each buy-and-sell transaction carries a price the traders agree upon, and the average of all those prices becomes the true value of the stock. For example, a stock that sells throughout the day for $24, $25, $26 and then $23 has sold for an average price of $24.50. In practice there are thousands of trades each day on an active stock. The price fluctuations are averaged in, and the stock ultimately reflects all of the pricing decisions that investors have made for the day. No one actually averages the price. The actions of thousands of investors simply result in a fair price at the end of the day.

Undervalued Stocks

Investors constantly seek stocks the market has overlooked. The efficient market theory states that prices reflect all current information, so those hunting undervalued stocks try to make educated guesses about future information. They look for trends in company profitability that others might not have noticed, or they try to predict the profitability of a product the company plans to introduce. However, the theory suggests that even all of those predictions about the future have already been priced into the stock.

Judgment

One famously successful investor who disagrees with the theory of stock market efficiency is Warren Buffet. In fact, he says he has made all of his money by finding inefficiencies in the market. He says the market can be efficient, but that it isn't always. A wise investor, according to Buffet, can find companies that have simply been misjudged by most investors. In Buffet's approach, if you have better judgment than they do, you can purchase a stock for a low price and watch it rise in value as other investors discover their mistake.

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About the Author

Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.

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