The market is an effective information-processing machine. Each day, the world equity markets process billions of dollars in trades between buyers and sellers—and the real-time information they bring helps set prices.
Markets have functioned throughout human history. The first market arose when a few people had something to trade and negotiated an outcome that the participants considered mutually beneficial. While markets have grown more complex and sophisticated, they still offer a simple and powerful way for people to exchange value and improve their well-being.
Entrepreneurs and investors meet in the capital markets. People supply capital with an expectation of receiving a reasonable return for its use. Their investment capital fuels economic activity. Businesses compete for this capital by offering higher returns, and investors compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that companies must offer returns in line with their perceived risk. When markets work properly, no investor can expect greater returns without bearing greater risk.
This doesn’t mean that a price is always right—there’s no way to prove that. But investors can accept the market price as the best estimate of actual value.
If you don’t believe that market prices are good estimates—if you believe that the market has it wrong—you are pitting your beliefs and hunches against the collective knowledge of all market participants.
The efficient markets hypothesis (EMH) is an organizing principle for understanding how markets work and what investors should care about. Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In the 1960s, he developed the efficient markets hypothesis, which asserts that:
- Securities prices reflect all available information and expectations.
- Current prices are the best approximation of intrinsic value.
- Price changes are due to unforeseen events.
- Although stocks may be mispriced at times, this condition is hard to recognize.
Viewing the markets as efficient has important implications. If current market prices offer the best available estimate of intrinsic value, stock mispricing should be regarded as a rare condition that cannot be systematically exploited through analysis and forecasting. Moreover, if new information is the main driver of prices, only unexpected events will trigger price changes. This may be one reason that stock prices seem to behave randomly over the short term.
The EMH implies that no investor will consistently outperform the stock market except by chance. Market efficiency argues that when securities become mispriced, market forces quickly push prices back toward fair value. This equilibrium does not depend on all investors having the same information or level of expertise. It only requires that many intelligent participants have information. No single investor will have all the information or know how to use it. In fact, no single investor can possibly have all the information, as it will be scattered among many participants who are all competing to maximize their potential profit as buyers and sellers. The market mechanism gathers the information, evaluates it, and builds it into prices.
It may be hard to conceive current stock prices as rational, especially when markets are extremely volatile. The EMH does not claim that markets are always rational or correctly factor information into prices. The only condition required is that a large number of market participants don’t consistently exploit price differences to outperform the market average. Also, market efficiency does not rule out the possibility that some investors will earn above-market returns. Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.