The Theory of Stock Market Efficiency

The Theory of Stock Market Efficiency

If you’re determined to make money with the stock market, you may invest plenty of time each week in learning as much as possible about it. By following the experts, surely you can predict where the stock market will go next and keep your risks low and your earnings high. However, the theory of stock market efficiency states that this is not possible since current prices are based on all currently available information.

Stock Market Efficiency Theory

Known as the efficient market hypothesis, the theory of stock market efficiency states that the price you see on an asset today is its true value, reflecting any data that could drive its price up or down. If the efficiency theory is true, all that work experts do to analyze the market is for nothing. Only insider information can help someone get a picture of a stock’s performance that isn’t reflected in what you can already see.

If the EMH was correct, it would be impossible to beat the market, as traders like Warren Buffett have managed to do. However, there are experts who insist there’s plenty of evidence to support EMH. Those experts advise investors to focus their efforts on a low-cost, passive portfolio rather than try to guess the market and take big risks.

Data Supporting the Hypothesis

Although there’s plenty of criticism of the stock efficiency theory, there’s also compelling data supporting it. Some of the most important research comes from Morningstar Inc., which included a report in its Active/Passive Barometer study that looked at fund managers’ returns across a variety of funds. Their study revealed that of those they reviewed, only two groups of active fund managers were able to outperform passive funds more than half the time.

Yes, it is possible to outperform the market using active investing techniques. However, very few are successful at it, statistically speaking. Overall, less than 25 percent of active fund managers can consistently outperform managers who specialize in passive funds.

Criticism of EMH

EMH states that all information is already factored into the stock prices being offered. One of the flaws in that theory, though, is that it assumes that everyone looks at that available information the same way. Analysis can vary from one person to another. A sudden drop in stock prices, for instance, will lead to different hypotheses from one analyst to another.

Investing approaches also differ among investors. Stock efficiency doesn’t take into account the fact that one investor may spend time researching a particular stock, then invest based on the future growth potential, while another may put time into finding undervalued opportunities. These varying approaches can lead to widely different results, even using information that’s already out there.

Types of Market Efficiency

Things aren’t completely black and white when it comes to the efficient market hypothesis. There are three versions of the theory:

  • Weak Form – With this version of the theory, proponents believe that current stock prices reflect all information available on past stock market prices. Therefore, technical analysis can’t help investors. However, under this version, fundamental analysis can be used to find undervalued and overvalued stocks. Reviewing a business’s financial statements can also boost an investor’s chances under this theory.
  • Semi-Strong Form – Proponents of this version of the theory believe that current stock market prices reflect all available information. Neither technical nor fundamental analysis will make any difference in investment results under this theory, and only finding out information that the public can’t access will elevate an investor’s chances above anyone else’s.
  • Strong Form – The strong version of EMH takes a hard line on predicting the market, stating that nothing can improve an investor’s chances, including information not publicly available.

Behavioral Finance and Investing

On the flip side of the market efficiency theory is behavioral finance, which dives into the thinking that no two people will take the same approach to investing. With behavioral finance, cognitive psychology is brought into the discussion to break down how various people build a portfolio. There are multiple biases that have been linked to investment behaviors, including:

  • Overconfidence – This bias leads an investor to overestimate his ability to choose the right investments.
  • Anchoring – Anchoring is a behavioral-based bias that leads someone to attach to a specific decision and refuse to let it go.
  • Hindsight Bias – It can be tempting to get caught up in past investment opportunities, supposedly seeing clearly how you should have been able to predict what happened. This idea can lead you to mistakenly believe you can estimate what will happen next, leading to costly errors.
  • Gambler’s Fallacy – When you flip a coin, you always have a 50 percent chance of guessing the correct answer, no matter what happened with previous flips. This perfectly illustrates gambler’s fallacy, which is an investor’s refusal to see that past events have no bearing on how a stock will perform today or in the future.

These are only some of the cognitive biases that influence the way investors behave. But by understanding your own biases and how they affect the investment decisions you make, you can improve your own ability to assess the market and use the information wisely.

The Risk-Reward Ratio

Even some who embrace the stock efficiency acknowledge that some investments are riskier than ever. For that reason, many investors use a risk/reward ratio when deciding how to invest. Individual investors may lack the skills necessary to balance risk as a professional fund manager would, so they may look for a higher potential reward to offset that risk.

Savvy investors calculate the risk/reward ratio before putting money into a stock. Even if, at the outset, the stock looks like a good idea, it’s important to put the ratio to work. Simply divide the likely net profit by the maximum amount you could possibly lose. The lower the risk/reward ratio, the better the investment is under this theory.

Passive Versus Active Investing

Avid proponents of the market efficiency theory believe you’re just as well-off investing in passive funds. Passive investors think of their investments as a long-term strategy, slowly earning money while keeping risk at a minimum. One popular form of passive investing is in index funds, which follows the top stocks in top indexes like the Standard & Poor's 500 or the Dow Jones. If one index leaves the fund, another steps in to take its place.

Active investing isn’t without its benefits, though. With active investing, a portfolio manager handles managing funds to always try to stay ahead of the stock market. The goal is to know when a stock is going to tank and take swift, appropriate action. However, this approach can be prone to serious losses, especially if the person managing the funds consistently makes the wrong decision.

The Greater Fool Theory

EMH is only one of several types of investment theory, including the greater fool theory. This theory says that as long as someone more foolish than you is willing to pay more for an investment, you can make a profit. Under this theory, you would simply need to choose a stock based on whether someone else might see it as worth more than it actually is, then invest at the going rate.

The problem with following the greater fool theory is that it encourages you to disregard important information such as valuation and earning reports. Ignoring that data could be dangerous, leading to a loss for those not paying enough attention to the available data. Besides, there are only so many foolish investors out there.

Predicting the Market

Many types of investment theory revolve around trying to predict what the market will do next. The 50 percent principle states that after a change in price, a stock will undergo a price correction of between one-half and one-third of that change. If a stock shoots upward in price, then there’s a slight drop before it continues, the 50 percent principle helps investors avoid panicking, allowing them to wait just a little longer.

Another indicator that wise investors watch is based on something called the odd lot theory. With this theory, investors monitor for signs that small, individual investors sell off their stocks, then invest. This theory is based on the fact that individual investors tend to make incorrect decisions about their investments. This practice works best when combined with other forms of analysis.

Predicting Financial Loss

Many other types of investment theory revolve around the concept of losing money. The prospect theory is one, stating that people tend to have a skewed view of gain and loss. To be more exact, fear of loss is far greater than the prospect of gain for many people. It’s understandable, but it tends to push people to invest in a stock that has a lower risk versus choosing one that has a greater chance of making money.

Another loss-related theory relating to investing is the rational expectations theory. This theory states that people will tend to act in a way that aligns with what they think will happen in the future. It means your investments are likely to be related to what you think is about to happen. If enough people do this, it actually can bring about that event in a sort of self-fulfilling prophecy.

Investing in Stocks

Even if you buy into the efficient market hypothesis, there are a few things you can do to maximize your profits when you’re building a portfolio. Even a little time researching can help you boost your earnings substantially.

  • Give it time ­– You’ve probably heard this before, but to be truly successful, you need the patience to wait it out when your stock values plummet. The market will have plenty of ups and downs over the years. Play the long game and you’ll have far better results.
  • Segment your investments – with so many stocks, it can feel a bit overwhelming to choose one. Experts recommend choosing a sector – preferably one you know well – and researching stocks within that niche.
  • Study all the players – Even if you have a specific stock in mind, make sure you take a look at all the players within that subindustry. If you research one company, look at similar information for its closest competitors to get the full picture.
  • Review financials – From a company’s 10-K and 10-Q, you can gather quite a bit of information. These documents are on file with the U.S. Securities and Exchange Commission. Also be sure to check the company’s website for any annual reports that might be posted there. Look at recent information on revenue, net income, earnings and return on equity.
  • Innovations and future plans – Read everything you can on the business, including how they’re working to innovate within their space. What plans do they have for the future? Do they seem to always be looking for ways to improve?

Although no amount of research can guarantee what will come next, the more you know, the more you can be sure you’re making a fully-informed investment decision.