Few things behave as erratically as the stock market. Prices seem to move without rhyme or reason. Companies see their stock values bounce around every day, even though they only announce new information a few times a year. What pushes for these changes and how can investors know a company is accurately evaluated?
Principles of Stock Trade
All trading hangs on the fundamentals of supply and demand. In any large market, people will continue to buy a desirable asset until the price rises to a point that is too high for consumers. Eventually, the price will drop until a usable equilibrium value is reached. The stock market follows this process as well—demand raises prices on assets until traders can no longer see a profit.
In the stock market, there is opportunity anytime an asset is mis-priced. Investors compete to buy assets that cost below their expected value or sell overpriced assets that others are willing to purchase above cost. With millions of people and computers all contending for the best deal, gaps are always shrinking and asset prices continually hone in on a global equilibrium, making values as accurate as possible.
The Efficient Market Hypothesis
Decades of observing investors push prices to profitable levels led economists to develop the Efficient Market Hypothesis (EMH). The hypothesis suggests that the open market (as a whole) knows everything about its assets and forces them to arrive at an accurate and efficient price.
The EMH is based on the concept of open trade in which all investors are attempting to make a profit. New public information about companies is absorbed into the market and investors consider how the price of affected assets might be different. Trades begin almost immediately. Those who believe that a stock is underpriced will buy it until the prices increase; those who think the stock is overpriced will stay out of the market or sell off, decreasing demand and lowering the prices.
After news hits a market, affected stocks may fluctuate wildly as investors and analysts overestimate the change in real value. Eventually, the pricing narrows and a stock’s price becomes more stable. This process can take minutes or days depending the gravity of the information and the number of markets involved.
New public information about companies is absorbed into the market and investors consider how the price of affected assets might be different. Trades begin almost immediately.
Economists watched the rapid reactions of the market and began to consider whether existing information was enough to predict future prices. Were there historical or hidden cues that would allow investors to beat the market?
Over time, economists arrived at varying levels of disagreement. Could the market accurately account for all information or just established information? To accommodate different views, economist split the EMH into three forms (or levels) of efficiency:
- Weak – This form suggests that the market only accounts for historical values and that future prices are not predictable from an analysis of previous prices. Under the weak form, investors cannot beat the market by analyzing the past trading but could predict the market through a financial analysis of a company’s public information.
- Semi-strong – The semi-strong form says that stock market reflects all public data (historical and present) whether it specifically deals with underlying assets or not. This level of efficiency suggests that investors cannot beat the market through financial analysis of a company. Only an investor with non-public or “insider” knowledge could regularly beat the market.
- Strong – The full extent of the EMH, strong form efficiency suggests that, somehow, all information (public and private) is incorporated into the price of an asset. A perfectly strong form means that no investor can consistently make gains in the market, no matter what information source is researched.
It can be difficult to make arguments for the strong form of the EMH. The idea that all information is taken into account would make “insider trading” ineffective and therefore invalidate any lawsuits against those who cheat the system. Clearly, some information is restricted enough that the market cannot efficiently respond.
On the other end, it is difficult to suggest that the efficient market is limited just to its weak form. Scores of teams use financial analysis to determine stock values, adjusting prices according to current public information.
Future Influence
No matter how efficient the market is, it is reactionary, not predictive. Since there is no way to know everything that will happen or how people will react to it, investors could consider future movements of a stock price to be random. Not that the market responds randomly to new information, but that the future news is ultimately random.
The EMH takes the idea of a random future to its logical conclusion. It says that an investor (who is not cheating) will not be able to regularly beat the average market return. He or she may get lucky one year, but over time success will be limited by the unpredictability of the market, just like everyone else.
Trader Efficiency
An interesting consequence of an efficient market is its ability to maintain intelligent traders that increase its own efficiency. Whenever an investor behaves more efficiently than others do, he or she meets with more success and is encouraged to continue investing. Whenever investors are inefficient, they lose money and are eventually forced out of the market.
Additionally, even if all current investors are unaware of an inefficient portion of the market, outside individuals are encouraged to become investors and begin profiting until that part of the market becomes efficient. The market is the survival of the fittest: it attracts and retains the investors who make it more efficient while forcing out those who disrupt it.
Problems
Though economists tried to describe the ideal working market with the EMH, efficiency is only half the story of how the real markets work. A market is affected by both the information it uses and the flaws of the traders using it.
If there is one problem with an efficient market, it is people. The EMH proposes the market logically processes all information to reach accurate prices. However, logic is rarely the only factor in human behavior. Traders may believe they are making the most rational decision possible, but they are often betrayed by unintentional biases and fear.
Many today take a view that markets are “micro-efficient” but “macro-inefficient.” A single stock can have all its earnings and underlying value scrutinized by hundreds of analysts until its price is ideal. On that individual, “micro” level, the market is acting with near perfect efficiency.
However, the flawless pricing of an asset does not protect it from the “macro” temperaments of the market. Sudden swings or unexpected events in other, unrelated investments might cause some investors to become overly pessimistic or could frighten others into completely irrational decisions.
One of the most problematic phenomena caused by human error is the creation of investor “feedback loops.” Examples of powerful feedback loops include asset bubbles and sudden crashes. In both these cases, the investors speculate (rationally or irrationally) on other investors’ behavior. If enough investors act on the same premise, the value of stocks will change and confirm the suspicions of the investors who had not yet acted. These investors then follow the first investors, and, in turn, influence even more investors to behave in the same way.
What Investors Should Know
According to the EMH, future stock prices are unpredictable and even intelligent investors cannot consistently get above-average market returns. However, some people—including high-profile investors such as Warren Buffet—have proven this wrong, regularly outperforming the rest of the market.
Techniques involving short-term trades or “timing the market” may seem like a way to advance profits quickly, but investor should avoid them. Temporary movements in the market are still effectively random. Significant short-term gains are not only rare but also invisible until after they have passed. Investing off speculation is more likely to hurt an investor’s finances than help them.
Though some individual cases prove it is possible to “beat the market,” investors should realize that most people will not be able to significantly exceed the average. “Talented” traders have huge amounts of information and experience at their disposal. The extraordinary people are those that are most likely to make extraordinary profits; average investors will be fortunate to make average returns.
Time is the best asset an investor can have. Even if an investor does not have prodigious skill and is limited to average returns, he or she can put them to effective use if committed to an investment plan. Prudent use of investing can help a person reach their goals, but they should never be fooled into thinking they can outsmart the market.
Fingerlakes Wealth Management, Inc. is a Registered Investment Adviser. This brochure is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Fingerlakes Wealth Management, Inc. and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Fingerlakes Wealth Management, Inc. unless a client service agreement is in place.
This article was written by Advicent Solutions, an entity unrelated to Fingerlakes Wealth Management. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Fingerlakes Wealth Management does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. ©2013 Advicent Solutions. All rights reserved.
