Efficient Market Theory

The efficient market theory states that the stock market reacts very quickly to new information, so at any given time the market contains the sum of all investors’ views of the market.

What does this mean to the average investor? Imagine you are reading an article in the Wall Street Journal.  Dell is going to release a new computer in three months that will blow away the competition.  You think maybe tomorrow you’ll call your broker and buy Dell, because obviously the price will go up.  The efficient market theory states, in no uncertain terms, you are too late! If you bought Dell stock as soon as soon as you read the article, or even as soon as it was printed, you are still too late.  A lot of more savvy investors and traders bought the stock before you, and drove the price up.  It doesn’t matter that the new computer won’t be released for 3 more months.  Whoever buys the stock first wins.

What does this mean to the savvy trader? Even if you have the fastest tools and the best information, you still have to work for it.  Trading is a competition.  No strategy will always work.  That’s impossible, because in order for someone to win, someone else has to lose.

Trade-Ideas offers a number of tools to help you prepare for that competition.  Our tools help you find trends long before they hit the newspaper.

Recently the efficient market theory has been misquoted a lot.  The efficient market theory does not say that the market is always correct.  It says that the market represents the sum of the information available and the choices made by traders and investors.  Traders and investors can be wrong.  Information can be wrong.  The best opportunities come when the market is temporarily wrong.  The smart traders will find the difference between the market value of a stock and the ideal value before the rest of the crowd does.

One successful strategy that many of our customers use is called “mean reversion.” This strategy is based on the idea that the market is not 100% efficient.  Time after time, the market will overreact to bad news.  Prices will move much further than they should.  Then they will move back toward normal.  Our tools are set up to help you see interesting events in the market as they happen.  And our tools also help you with the statistics to know what’s normal and what’s out of range.

DEFINITION of 'Efficient Market Hypothesis - EMH'

An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperformthe overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

BREAKING DOWN 'Efficient Market Hypothesis - EMH'

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.