Just How Efficient is the Market?

If you are a mutual fund investor, you've probably heard talk of the Efficient Markets Hypothesis (EMH, not to be confused with EMT or Emergency Medical Technician) being bandied about at one point or another.  In a nutshell, EMH maintains that the stock market and similar markets are efficient.  That is to say, the price of a stock at any given time will express ALL the information available about the stock at the time, and will usually match the fair value of the company.

Obviously, not every stock will exactly match the fair value of the underlying company at every moment; if they did, there would be little change in stock prices on a daily basis, rather than the swings that we see.  EMH holds that these variations are random and unpredictable, and will revert to fair value as a result of investors attempting to exploit the deviations from fair value.  In a liquid, large market with low costs and people looking to gain advantage from these (temporary) variances, the stock price will soon revert to fair value, at least until the next inefficiency arises.  While it's possible for some investors to benefit from these inefficiencies, doing so depends on luck and not skill, according to EMH.

As with any such hypothesis, of course, there are challenges to EMH.  The most obvious examples are investors such as Warren Buffett who proved able to beat the market repeatedly.  There are also runs on the market, both on the upside (such as the tech boom) and the downside (as during 2008) where investors end up distorting the market in ways that pull prices away from their fair values in a concerted way.  That the stock market is efficient is far from a settled fact.

Efficient Markets and the Individual Investor

compact-flourescent-bulbAll this might seem like just an academic argument, but it has some very real consequences for your portfolio.  If the EMH theory is correct, your best (and in fact, only sensible) investment is in index funds; barring some lucky (and unpredictable) breaks, neither you nor a mutual fund manager can hope to beat the market, and the best you can do is match the market gains while spending as little money as possible.  If EMH does NOT hold, then beating the market via skill could be possible, and finding good stock investments or a solid mutual fund manager looks more reasonable.

So, which is it; do EMH principles apply or not?  I hold that the answer depends on what segment of the stock market we are considering.  Remember, there are several points that need to be true for markets to be efficient:

-Liquid: It should be possible for shares to be bought and solid easily, enabling the price to easily move back to the fair value for the stock.
-Large: A large market both increases liquidity and helps to ensure that information is widely disseminated, enabling changes from fair value to be easily discerned.
-Low Costs: Low costs increase the liquidity of the market, as well as decreasing the shift in value needed for the investment to be profitable.
-People Looking to Profit from Variances: Without people buying undervalued stocks and selling (or shorting) overvalued ones, the stock prices will stagnate, preventing the stocks from returning to fair value.

The closer a particular segment of the stock market is to meeting these criteria, the more efficient it will be.  For large cap stocks, the market is pretty dang efficient; the market for the AT&Ts and Wal-Marts of the world is large, liquid, and filled with people who will pounce on undervalued or overvalued stocks, pushing them towards their fair value.  On the other end of the spectrum, penny stocks tend to be illiquid, have a small market, and typically have added fees that increase the investment costs; all of which point to a really inefficient market that could potentially be exploited by a savvy investor.  (Although, I'd tend not to recommend penny stocks, as the lack of regulation and easy manipulation by unscrupulous charlatans makes the penny stock market highly risky.)  Most other markets fall somewhere in between; small-cap stocks are going to be less efficient than large-caps, but more efficient (and I would add, safer) than penny stocks.

What does this mean for your portfolio?  If you seek market inefficiencies, look for shares that are rather illiquid (think small cap); it'll be longer before the market as a whole attempts to change the incorrect valuation, allowing the them to get further from the fair value (and potentially increasing your profit, with a well-chosen stock).  When investing in larger-cap stocks, don't expect market adjusted to drastically and permanently shift your investment value, all public news will be priced into the stock already.

If you're more of a mutual fund investor, you'll likely have an easier time finding mutual funds that beat their respect indexes if you look at smaller cap funds.  A fund manager limited to picking from the S&P 500 for the companies in which the fund invests will have to deal with a liquid market keeping the valuations from getting too far out of touch with the fair market value. Larger cap investments should be considered more for the expected growth and possibly dividends.

The Efficient Markets Hypothesis provides some insight into the method behind creating index funds in the first place.  Whether you believe it's a fact of investing life, think it's a load of crock, or somewhere in between will impact just how much of your money you want to put into actively managed investments.  Regardless, the more you learn, the better an investor you'll become, so enjoy the new knowledge!

(Image Taken from The Daily Gazette at Swarthmore)

Leave a Comment

Your email address will not be published. Required fields are marked *