The efficient market hypothesis says that no matter what you do, there is no way to beat the passive returns of the stock market. The theory holds that there is no money to be made by actively trading in the market. Less militant versions of this hypothesis simply say that it is so difficult to beat the passive returns of the stock market that it is impractical to even try…and that if you somehow do outperform the passive returns of the stock market, then it was a matter of chance or luck and not skill or ability. It is an idea that is largely harbored in academic circles and it is based on one fundamental idea:
1. Stocks Reflect All Available Information
The underlying premise of the efficient market hypothesis is that the value of the stock is somehow "in the stock", that stocks have "intrinsic value", a ‘true" value, or one "correct" value which is determined instantaneously as new information becomes available to the market. Because of this, there is really no way for investors to outpace the returns of the broad, underlying, index that that stock belongs to.
So, for example, if you were investing in a stock that was listed on the S&P500, you would be better off just investing in the broad index (through an index fund, for example) because you will never outperform the collective stock market.
This view promotes the idea that the stock market is always right, and that’s why you cannot "beat the market".
The Problem With Buying Index Funds AKA "The Efficient Market Hypothesis"
The efficient market hypothesis is correct in assuming that stock prices are sensitive to information. They are. Stocks (and all other investments) are affected by information relevant to the investment. But, just as with the subjective theory, the intrinsic theory is also arbitrary in the pricing of stocks. The reason for the automatically correct and instantaneously self-correcting stock market is unknown and unknowable. It apparently "just happens".
There are three reasons why the efficient market hypothesis is wrong:
1) There is always a time delay between when information comes to the market and when information can be acted on. Buildings are not built instantaneously, iPhones are not created instantaneously, and research-particularly stock research-does not happen instantaneously.
2) Stocks do not reflect all available information. Why? This is partially due to the illegality of insider trading, and various Government regulations. For example: If Warren Buffet traded on inside information about Berkshire Hathaway, he would be promptly arrested. Since insider trading comes with severe civil penalties of 3 times the amount of money gained or loss avoided, fear keeps many CEOs and insiders from investing on their information. And, this inside information does not get reflected in the price of a stock—at least not immediately.
In other words, the stock market does not reflect the most informed traders. The most informed traders are kept from investing on their information which effectively prevents their information from being traded on by other investors.
3) Someone must be trading. There must be someone there to make the market efficient because markets don’t exist without investors and traders. If someone is selling stock for $23 and someone buys it for $23, then the price is made at $23. If a seller offers stock for $23, but negotiates with a buyer and sells for $20, then the real price of the stock is $20, not $23, because the stock actually sold for $20, and reality is what it is regardless of anyone’s thoughts, wishes, or desires. The seller may have originally wanted to sell for a higher price, but did not. The seller, however, wasn’t forced to sell his stock lower. He agreed to do it-voluntarily. It was the two participants that came together and agreed voluntarily on the price that made the price what it is. And this principle of trade (the trader principle) is what makes the stock market efficient.
It is the people exploiting the small developing patterns, the individuals acting on new information as it comes to the market, it is the savvy investors who are willing and able to buy and sell stock based on that information that creates the efficient market. In short, the reason the market is efficient is because there is money to be made, not because there is not.
If the intrinsic efficient market theory were valid, then there would be no incentive for anyone to buy any stock because there would be no opportunity for profit. Additionally, if there was no profit to be made by selling, there would be no incentive for an individual to sell their stock. There would be no reason to invest in the stock market, and quite possibly no way to do it-not even in an index mutual fund which would be holding stocks in a stock market where no one would be willing to sell because there would be no incentive to do so. There would be no functional stock market.
Incidentally, the efficient market hypothesis encourages its practitioners to "buy and hold" stocks perpetually since the theory holds that active investing is fruitless. But, because of active traders making the market efficient, and because of natural (and also often unnatural) business cycles, this has also led many adherents of the efficient market hypothesis to have their investment portfolios wiped out during a market correction. As recent evidence of this, witness the amount of money index fund investors lost during the stock market crash of 2008. Investors had literally 10 years worth of investment returns completely erased because of this investment philosophy.
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