Efficient Market Theory
What Is Efficient Market Theory?
Efficient market theory is a financial theory that states that asset prices fully reflect all available information.
In other words, it assumes that security prices always accurately reflect the true value of companies. Therefore, it follows that price variations are random and cannot be predicted in any meaningful way.
Even after an event which could affect a company’s prospects occurs, share prices are expected to quickly revert back to their original levels.
Proponents of this theory believe that if investors analyze a company in great detail, they can’t expect to earn above the risk-adjusted rate.
Since it’s not possible for an investor to know more about a corporation than what is already reflected in its price, trying to gain a competitive advantage through knowledge is pointless.
To understand this concept better, consider an analogy from everyday life:
If someone placed a sell order for 1,000 shares at $100 each for Apple Inc., it would indicate that the seller believes that Apple shares are currently worth $100 or less.
In turn, a buyer placing an order to purchase those 1,000 AAPL shares at $100 each – even if it is for a slightly lower price – would mean that they believe Apple’s current market value is greater than $100 per share.
So, even though someone might feel that the stock is currently overvalued at $100 per share, they wouldn’t attempt to buy it unless they think its price would increase.
This brings us back to the efficient market theory, which states that any new information will be immediately reflected in a company’s stock price.
How Does It Work?
Market efficiency is determined by how fast new information moves throughout the market and gets reflected in security prices.
When a significant piece of news about a company becomes public, it’s usually reported on one of several financial media outlets.
The price of the stock will move up (or down) as soon as those media outlets report this news.
For instance, a natural disaster might cause a company’s stock price to drop as investors price in lower earnings.
In turn, those prices will reflect the information from those reports and return to their original levels as soon as the event has passed.
In addition, if a company makes an announcement about an upcoming product launch, its stock price will rise as soon as the announcement is made.
However, if the company admits that it’s struggling financially and doesn’t expect to be profitable in the near future for example, its share prices would fall on the spot.
Forms of Efficient Market Theory
Generally, there are three main forms of efficient market theory: strong, semi-strong and weak.
This is the most extreme form of market efficiency. The theory states that it’s impossible to make money in the market over any given period of time. Investors are always right since their expectations are already reflected in stock prices.
For example, if a stock price drops from $10 to $9 in response to negative news, it can be considered efficient since the information was already priced into the market.
If neither new information nor intangible factors can cause stock prices to deviate from their intrinsic value for any period of time, then the market is considered to be perfectly efficient.
The main difference between this and strong form is that in semi-strong market efficiency, future events are also factored into a stock’s price.
However, according to this form, it’s still not possible to predict short-term price movements.
In turn, short-term price movements become predictable if they’re based on new information that’s already been reflected in a stock’s price.
For example, wide swings in a company’s share price following an earnings report is considered semi-strong efficient market behavior because the news was expected.
Here, market efficiency refers to security prices that reflect all information known by relevant market participants at a point in time. This means that both public and private information is included in asset pricing decisions.
For instance, if an investor knows that a company’s earnings will increase by 20% in the next quarter, it would be reflected in the price of its shares.
Thus, someone could trade these shares at an above-average return if they act before public knowledge is released.
What Does It Mean for Markets To Be Efficient?
If a market is efficient, prices reflect all available information. This means that changes in stock prices cannot be predicted based on past or present data.
By extension, this would suggest that an investor may as well invest randomly since it wouldn’t matter from which stocks they choose to buy if their returns are expected to mirror those of the overall market over time.
However, there are some things to bear in mind when considering an investment strategy that reflects these ideas.
First, the efficient market hypothesis refers to stock prices rather than individual stocks themselves. This is why it’s still possible for investors to find undervalued stocks with low price-to-earnings ratios or high dividend yields.
Second, the theory suggests that it’s impossible to consistently beat the market. However, many investors have historically found ways to do this by identifying information ahead of its release.
What Can Make a Market More Efficient?
Markets can become more efficient if they have high liquidity, where it’s easy for someone to find the price they want.
Second, decentralization refers to how information is distributed around market participants. If information is held by too few people or agencies, then the market may not be as efficient as it could be.
For example, if an insider or large investor makes a trade, chances are it will have an impact on the market.
Third, transparency also refers to how information is distributed. If there’s no access to public data, then it becomes more difficult for investors to make their own independent estimates about future events that may influence prices.
Finally, securities trading should be organized around the law, which has clear ownership rights and price discovery.
How Has It Evolved Over Time?
The efficient market hypothesis was first made in the 1950s and 1960s by MIT Sloan School of Management professor, Paul Cootner.
It gained popularity during the bull market of the 1980s.
However, its credibility took a hit after it failed to explain why markets crashed at the beginning of the 21st century.
Moreover, in the 1990s, behavioral finance emerged, which argued that markets weren’t always rational.
Instead, investors often made irrational decisions when they were influenced by emotion (e.g. buying when the market is rising) or in response to recent news events (e.g. predicting a stock will rise shortly after hearing good news about a company).
The goal of efficient markets is to increase the likelihood that a security’s price reflects its intrinsic value. The implications of efficient market theory can sometimes be misunderstood to suggest that stock prices are never predictable.
However, the theory only refers to how changes in prices cannot be predicted based on past or present data.
Thus, while it’s impossible for investors to consistently beat the markets by predicting short-term price movements given this information, other methods for gaining an advantage exist.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.