The Efficient Market Hypothesis and Stock Investing

by | Aug 24, 2023 | Research

The internet is filled with stories of traders who chose the right stock at the right time and turned $100 into a fortune. So, you may be surprised to learn that the theory behind common stock analysis techniques – the efficient market hypothesis – claims that it is nearly impossible to achieve higher than average returns by finding undervalued stocks.

If you take the time to understand this theory – and its limitations – you can gain a better understanding of how stock markets work. With this information, you can spot and take advantage of opportunities to increase your investment returns.

The Efficient Market Hypothesis

The efficient market hypothesis was published by Eugene F. Fama in 1970. This theory asserts that all publicly available information is factored into a stock’s price immediately. It is frequently used to create financial models and forms the foundation of many stock analysis tools including the discipline of technical analysis.

If you subscribe to this theory in its purest form, you believe that all people who own or are considering buying a stock have digested public news and financial data the moment it is released. Then, they adjust their estimates of a stock’s fair value – their intrinsic value calculations – and place trades based on the new valuations. These trades cause the stock’s price to rise or fall to reflect the new information. Since the theory asserts that this process is instantaneous, it also means that stocks are never undervalued or overvalued.

Are Stock Markets Truly Efficient?

While the efficient market hypothesis is helpful to financial models, it is not perfect in practice. If it was, a company would release a press release announcing lower profitability and its stock price would immediately fall to account for the news. In reality, it takes time for investors to access information, make forecasts for how that information could impact a company’s profitability, and then act on those forecasts.

In addition to information delays, there are several other factors that contribute to inefficiency in stock markets. These include:

  • Emotion. Sometimes traders don’t trade based on information. Instead, they might buy a company’s stock because they like the company, the CEO, or the product. Similarly, some traders sell based on a gut feeling or a Reddit thread, rather than concrete numbers. These factors can lead stocks to trade at prices outside their intrinsic value.
  • Few trades. Some stocks have few buyers and sellers. In a small pool of investors, one large trade can cause the stock’s price to shift dramatically.
  • Inaccurate information. Investors receive information from unofficial sources – like news articles, social media, friends, and family. This information can be inaccurate or purposely distorted.
  • Transaction delays. An efficient market relies on investors trading immediately, but most people are not watching their portfolio 24/7. For this reason, trading delays can lead to a lag in price changes.
  • Trading costs. Some investors delay or choose not to trade when the cost of the trade outweighs the potential gain from acting on the new information.

With advances in technology, many of these inefficiencies have been lessened. Now, investors can receive a notification when a company makes an announcement, read that announcement quickly, then place a low-cost trade online in response. In theory, further advances – particularly in AI and trading “black boxes” – could lead to perfectly efficient stock markets in the future. However, a stark reality remains – inefficiencies still exist and likely will for the foreseeable future.

The Efficient Market Hypothesis in Stock Trading

Since stock markets are not perfectly efficient, there are still ways to profit from the inefficiencies that exist. One way to do this is to use fundamental analysis to determine a fair price – a.k.a. intrinsic value – for a stock as new market data becomes available. Once you’ve found the intrinsic value, you can compare it to the market price to find stocks that are overvalued or undervalued. Then, technical analysis can help you choose an advantageous time to trade.

If you are like most people and don’t have the time to perform this detailed analysis yourself, an experienced financial professional can take the work off your plate. An advisor that specializes in stock trading can help you identify inefficiencies and adjust your portfolio to take advantage of them.

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Article Topics: Financial Planning | Stocks