Question

Is the market really efficient? Two sources (notable)

Answer 1

An important debate among stock market investors is whether the market is efficient - that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally.

1. the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to ascertain what a stock should be worth under an efficient market.
2. under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds: their equal possession of information means they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if one investor is profitable, it means the entire universe of investors is profitable. In reality, this is not necessarily the case.
3. under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. This would naturally imply, as many market experts often maintain, that the absolute best investment strategy is simply to place all of one's investment funds into an index fund, which would increase or decrease according to the overall level of corporate profitability or losses. There are, however, many examples of investors who have consistently beat the market - you need look no further than Warren Buffett to find an example of someone who's managed to beat the averages year after year.

4. When external forces impose very strict disciplines, e.g., government regulators, senior creditors, credit rating agencies, and the plaintiffs' bar, such strict regulations or control tends to stifle innovation and productivity. It is important to note that the government does not have a monopoly on actions which stifle innovation and productivity. The same disease exists in the private sector, where, say, financial institutions follow overly strict lending practices. However, it is Professor Shubik's observations that no financial markets of any sort, whether banking, insurance, finance, or passive investing, can approach instantaneous efficiency unless they are strictly regulated both by government and private sector forces.

   When external forces impose little or no discipline, e.g., boards of directors rubber stamping top management compensation and entrenchment packages, or passive shareholders' proxy votes, an environment is created which will be characterized by corporate inefficiency, frauds, and a gross misallocation of resources.