Lessons from Mr. Market Derived from the “Efficient Market Hypothesis”:
- The Market Has No Memory – Despite historical dynamics creating psychological expectations, research does not confirm a correlation between past and future dynamics. You’d be fooling yourself if you think that just because the price has fallen significantly, it will inevitably return to its original level. Predicting this is impossible.
- Trust Market Prices – In efficient markets, the price incorporates all available informational data. You might think you can value a stock better than the market. This may be true, but only if you are smarter than all market participants or know something that no one else does (financial hell is full of people destroyed by such delusions).
- Prices Can Tell a Lot About the Future – They reflect investor expectations. For example, when looking at short-term and long-term interest rates, you can infer market expectations regarding changes in interest rates.
- Don’t Be Blinded by Sentiments – Mergers, acquisitions, and similar high-profile operations for hedging purposes don’t actually create value. Just as changes in leverage don’t alter investor returns. Investors can hedge or leverage independently and more cheaply.
- All Stocks Are the Same – Investment is made for profit, not for emotional attachment to specific stocks. Therefore, stock prices are highly elastic. Investors can freely switch if they find a better combination of risk and reward.
The Efficient Market Theory was developed by Nobel Prize-winning economist Eugene Fama. The theory is presented in three forms: weak, semi-strong, and strong efficiency.
- Weak Efficiency means stock prices reflect historical dynamics, and you can’t make extra profits by observing this dynamic.
- Semi-Strong Efficiency means stock prices reflect all public information, and you can’t make extra profits by analyzing this information (e.g., financial statements).
- Strong Efficiency means stock prices reflect both public and inside information, and you can’t make extra profits in any way.
This is the theory. What happens in practice?
The theory is largely supported by research and analysis of historical facts (for example, active hedge funds do not show better results than market indexes). However, there are exceptions explained as follows:
- Arbitrage Opportunities Are Sometimes Limited – For instance, you might see a stock that is significantly overpriced, but practically you can’t “short” it.
- Historical Bubbles, which raise the biggest questions regarding the theory, are explained by the “agent problem” (fraud by managers and other involved parties) and irrational behavior (Behavioral Finance), which is a topic for another discussion.
Source of opinions:
Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myers
