Is the Stock Market Really Efficient?

For those in the financial advising field, one of the more controversial concepts is the “Efficient Market Hypothesis” developed by Eugene Fama in the 1970’s. The idea is that stock prices reflect all available information, so there is no way to consistently “beat the market” when adjusting for risk. That doesn’t mean you can’t outperform other investors with good behavior by taking more risk when others are fearful and less risk when others are greedy. But it does mean that you are unlikely to outperform the broader market by trying to time the market or pick individual stocks. 

For example, imagine you are bullish on a new small tech stock steadily gaining market share from the “Big Tech” companies. The stock has started to go up, but at this pace, you think it could 10x from here. Of course, they could also run into any number of issues (running out of money, imbalance of employee compensation, insider fraud, etc.) and go under. The efficient market hypothesis would say that today's price is “fair,” given the potential upside and downside.

Many have pushed back on the efficient market hypothesis with the recent AI stock wave carrying the market. So many people called this the next big wave well before a run-up in AI-related stocks. If the market was efficient, how did they know beforehand?

Recently, Fama sat down for an interview to back up his long-standing market hypothesis. He counters the backlash against his hypothesis, “If prices are obviously wrong, then you should be rich…” Fair point. Taking the example of the AI boom, many more investors would be far better off if it was so obvious ahead of time. The reality is that sometimes obvious things turn out to work, sometimes they take a very long time to work, and sometimes they don’t work at all.

He admits that “efficient” was maybe not the right word – “I just couldn’t think of a better word. It’s basically saying that prices are right.”  He goes on, “The question is whether it is efficient for your purpose. And for almost every investor I know, the answer to that is yes. They’re not going to be able to beat the market so they might as well behave as if the prices are right.”

That last takeaway is gold. The reality is that there probably is some inefficiency in the market – but that doesn’t mean you will be able to find it and benefit from it consistently. Far more investors would be much better off by having a diversified portfolio that matches their income needs to their risk assets (less risky assets for short-term needs) and rebalancing to allow them to take risks at the right time.

Happy Planning,

Alex

This blog post is not advice. Please read disclaimers.