The other day I got to thinking about the Efficient-Market Hypothesis (EMH). EMH is the idea that the stock market is “informationally efficient,” meaning that a stock is always accurately valued at any given time based on the information that is publicly available about the stock at that time. In other words, day-to-day changes in share price are simply due to changes in information available to the market.
I do not subscribe to this theory, and neither should any other stock trader. Here’s why: if you believe EMH is true, there’s no point in trading stocks. According to EMH, there’s no such thing as an “under-priced” stock, and the smartest, hardest-working investment banker at Goldman Sachs has no trading advantage whatsoever over your doofus cousin who once tried to make “Super Deodorant” out of after-shave, cologne, a bar of soap, and a pack of Doublemint gum. It’s pointless. If EMH is true, every stock is accurately priced at all times.
But what would EMH defenders say about my market out-performance over the five years I’ve been trading stocks? What would they say about the fact that I have consistently bought stocks that have subsequently risen in price? If those stocks weren’t under-priced at the time I bought them, how did I get all this money in my trading account??? According to EMH, those stocks were not under-priced when I bought them. My valuations were simply incorrect. When I bought Apple at a split-adjusted $70 in 2013, it was apparently not cheap. Neither was Pfizer when I bought it at $14.20 in 2009. Neither was Alcoa at $7.66, General Electric at $11.15, Dupont at $23.07 or AT&T at $24.47. According to EMH , I just under-appreciated the risk facing all of these companies at the time. And here I was naively thinking that these were all wonderful companies that simply got temporarily dragged down with the rest of the market during a recession. Boy was I lucky…
I will gladly admit that stock prices do reflect all information that becomes available to the public eventually. But in my humble opinion, there is nothing efficient about it. In fact, market inefficiency and periodic inaccuracy provide the windows of opportunity that I pounce on to make winning trades. If stocks were never mis-priced, there would be no way to consistently outperform the market.
But as a theory, EMH makes a lot of sense. In a perfectly efficient market, why would a stock remain under-priced if there is public information indicating that it’s under-priced? That’s easy money for any trader that recognizes that discrepancy between price and value. And, in my opinion, within that last sentence is the root of the reason EMH does not hold true: …for any trader that recognizes that discrepancy…
Information doesn’t move share prices. Traders do. Buys and sells move share prices. Yes, new information can instantly change the valuation of a stock. But it’s up to the action of traders to actually move the share price. And traders, despite what many may think, are members of the human race. We may have opposable thumbs and dominion over the powers of fire and the wheel, but we are not models of efficiency. I’m well aware of what your mother told you when you were a child, but you aren’t perfect. I know it stings, but you’ll come to terms with it eventually.
The level of inefficiency differs from one trader to the next, but it’s always there. So what actually happens when a big piece of news comes out? Let’s say, hypothetically, that a large Asian casino operator discloses in its quarterly earnings report that one of its branches is being indicted for violation of financial laws. I’ll call this hypothetical company “Pelco.”
As soon as news such as this comes out, many of the most efficient traders will sell shares, recognizing that the news adds an element of risk to the future of the company that is not reflected in the current share price. Many of these traders will short shares of Pelco until the stock reaches whatever price they deem to be the new “accurate” representation of its value.
Many of these most efficient traders will simply dump the shares they owned and move on to something else, completely forgetting about Pelco all together.
Many traders, such as myself, might recognize that news such as this will likely cause a temporary drop in share price. However, as a young man of only one score and ten years of age, I have plenty of time to hold my shares and wait for this temporary setback in Pelco’s progress to be resolved.
Many other traders are so busy with work, family, and/or Super Deodorant that they may not even read the news about Mel- er… I mean “Pelco” until the end of the week or the end of the month. These traders might sell their shares sporadically throughout the weeks following the news.
Many traders might get spooked by the news and sell immediately. But after work, they go home, have a couple of beers, and think to themselves, “Hey, who among us hasn’t been indicted at least once or twice in our lives? Even Jesus Himself once said, ‘Let he who is without indictment cast the first stone!’ Or something like that… Maybe I was a bit too hasty in selling my Pelco shares.” These people might buy those same shares back the very next day.
I can go on and on, but the idea is that traders, who are solely responsible for changes in share price, are not perfectly efficient in their thoughts, emotions, or actions. And even the most efficient and most wealthy traders often do not have the resources to move a large-cap stock to the “right” price instantaneously and all by themselves.
This should be good news to all traders: Efficient-Market Hypothesis is garbage, and it’s because of this stance that I continue to actively trade. I believe I can do better than the overall market, and my performance over time supports that belief.
Are you frustrated with how stock prices seem to move so randomly? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common Sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and tradingcommonsense.com is always available on your local internet!