The Efficient Market Theory is a core topic studied by finance students all over the world but its discussion is not just for us finance nerds as each investor's viewpoint on the theory should inform their approach to investing.
I have just revisited the topic in my Chartered Financial Analyst candidate studies and thought it was worth taking readers through a discussion of this topic. So what is the Efficient Market theory and how might it be applied to building investment portfolios?
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The efficient market theory purports that current prices of securities reflect all information about that security. If you follow the line of thinking underpinning this theory, you are encouraged to believe that you are unable to find mispricing of securities and as a consequence the effort and costs involved with trying to find pricing anomalies only leads to increased costs which results in reduced performance.
On the other-hand, if you believe that markets do not factor in all available information into the price of a security, this mispricing can be manipulated to produce out-performance.
Why might markets be efficient?
- large numbers of profit-maximising participants analyse and value securities
- new information regarding securities comes to the market in a random fashion
- profit-maximising investors adjust security prices rapidly to reflect the effect of new information
The implication is that if markets are efficient the current price of a security factors in all information about that security and identifies the risk involved with investing in that security.
There are three main hypotheses about efficient markets:
1) Weak-form
- Assumes that current prices fully reflect all security market information and therefore past rates of return should have no relationship with future rates of return
2) Semi-strong form
- Asserts that security prices adjust rapidly to all public information and suggests that investors who base their decisions on any new important information after it is public should not derive above-average risk-adjusted profits
3) Strong form
- Contends that stock prices reflect all information from public and private sources and suggests that no group of investors should be able to consistently derive above-average risk-adjusted rates of return.
So what has the research found?
To be frank, the evidence is mixed with some findings that strong form efficiency can not be discluded while others find that some examples of semi-strong efficiency do not hold up.
Our reading of the research shows that no investor or even professional fund manager can consistently gain a reliable advantage over all of the other market participants. Asset prices quickly and fully reflect the knowledge and expectations of investors.
The implication of this conclusion is that stock selection and market timing provide little value.
So what is our approach?
Therefore we do not pick particular stocks or markets and consider that trying to time market entry is not productive.
To take a look at some of the research in more detail please take a look at our "
Research Based Approach" page on Efficient Markets.
