I’ve mentioned before that, if there’s one thing from the academic world of finance that I think more investors should know about, it’s the concept of market efficiency.
To provide some background information: In an efficient market, the current price of each investment would reflect all known information about that investment.
In other words, in an efficient market, all public information would already be reflected in a stock’s price, so there would be nothing to gain from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you. Similarly, there would be no benefit to trying to time the market by determining whether the market as a whole is underpriced or overpriced.
Volatility and Market Efficiency
Many investors look at periods of market volatility and ask how such things could happen if markets were efficient. That is, how could the price of the market have been correct a month ago, and be correct today even though it’s 10% lower?
As explained by Eugene Fama*:
“The market can only know what’s knowable. … When there’s a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices.”
In other words, efficient markets only reflect currently-known information. When previously-unknown information becomes available, market prices change accordingly. If that new information is surprisingly bad or surprisingly good, market prices will change dramatically and suddenly.
That’s how an efficient market should work.
Is the Stock Market Perfectly Efficient?
For the record, I don’t believe the stock market is perfectly efficient all the time. There have been a handful of investors throughout history who appear to have successfully identified inefficiencies that they could reliably exploit for profit. (And there could certainly have been more who succeeded in keeping their identity and methods a secret.)
That said, for most investors, myself included, it’s not worth the time and money to try and seek out inefficiencies, because:
- They’re hard to find (and they may disappear soon after being found if other investors find out about them as well), and
- Even if you think you’ve found one, it may turn out to have been nothing other than randomness, and if you bet heavily on it, you could end up in a heap of trouble.
Similarly, it’s no easy task to find a fund manager who will reliably outperform the market. In order to do so, you’d have to identify an inefficiency in another mostly-efficient market: the market for fund management skill.
*Update: The video from which that quote came has since been taken offline.