Efficient Market Theory is the hypothesis that the market can always adequately determine the value of an equity, commodity or security. In layman’s terms this means that the price of a stock or commodity is its’ true value. This belief is the basis of many modern schools of investing and of some theories of capitalism.
Believers in the theory maintain that the market will always determine the real price of something in the end. If it is overpriced its price will fall to reflect its true value. If it is under-priced the price will rise to reach the true value. Many efficient-market practitioners invest purely based upon price and ignore all other factors. Others practice technical analysis which tries to predict the future value of stocks or commodities.
Why the Market is not Efficient
Even though this hypothesis is very attractive it is not true. The market often overvalues or undervalues investments. It often fluctuates wildly which means prices will not actually reflect what something is worth.
There are two big reasons why the efficient market theory can not work. The first is that most of the decisions to buy and sell are made by people whose decisions are based largely on emotion. Individuals sell when the market is falling out of fear and buy when it is riding out of excitement. They also make many decisions based on intuition, prejudice and personal beliefs.
The second reason is that the players in the market cannot have all the information about the equities, commodities and securities they are trading. Outside events can have a profound impact on markets. The price of copper could be affected by a miner’s strike or the outbreak of civil war in a copper mining country. Copper traders may not be aware of these developments until they see them in the news.
Corporate executives often hide or try to hide the true data about their enterprise’s performance even though laws mandate such disclosures. If they cannot hide information such as sales figures executives may distort, falsify or obscure it. This means it may not be possible to determine the true value of a stock.
A Classic Example of Market Inefficiency
An excellent example of market inefficiency in action is the trading of gold as a commodity. Gold is a commodity yet its price is deeply affected by emotion and irrational expectations. Many people have almost blind faith in the precious metal while others purchase it out of fear.
In the forty year period from 1971 when trading started until 2011 the gold price fluctuated wildly. The metal hit its highest price around $650 an ounce in 1980 and 1981. This price was based purely on fears on irrational fears about the economy and Soviet military moves during the Cold War. Gold then fell drastically to less than $300 an ounce during the late 1990s (if adjusted for inflation it’s fall was even higher). Later it regained some of its value by 2010 and 2011 but never reached the high of 1980 when adjusted for inflation.
The example of gold shows us that the market is not very efficient. In fact it can be highly inefficient at times. Nobody should depend purely upon the market as a determination of value.