Are Stock Markets Efficient?

The Efficient Market Hypothesis

An age-old debate in the financial world is whether or not the stock market is truly efficient. Now, you may wonder, what does that mean? Why wouldn’t it be efficient?
In this case, “efficient” means that prices reflect all available information. Okay, what does that mean? In essence, what the Efficient Market Hypothesis argues is this: The price of a stock in the market always reflects the fair value of the stock. Any information or news about a company gets quickly factored into its stock price so that nothing is overpriced or underpriced, and there is no way for you to take advantage of mispriced stocks and consistently beat the market (gain returns greater than that of the average market).

But seriously, 100% efficiency?

But how can that be true? We know of investors who have consistently beaten the market, like Warren Buffett for instance, who made billions from investing in undervalued stocks. People and institutions still invest based on fundamental and technical analysis and make excessive profits, which shouldn’t be possible according to the efficient market theory. Supporters of the theory claim that beating the market happens only through sheer luck. On the other hand, there is also evidence showing that the market is indeed efficient to a significant level. In 1986, NASA’s space shuttle Challenger exploded soon after lift-off, killing all crew members on board. It took several months for a special committee to figure out which of the shuttle components had been faulty. However, the stock market was much quicker. Minutes after the crash, the stocks of the four companies who had manufactured the parts for Challenger started to fall, and by the end of the day only one of those four companies had fallen by about 12% while the other three had fallen about 3%. The market in its collective wisdom had almost immediately labelled the culprit correctly. What is this if not an example of its efficiency?

Of course, the collective beliefs of investors is also what leads to financial bubbles, from the tulip mania of the 17th century to the housing bubble that caused the 2008 crisis. Not exactly a point in favour of efficient markets.
Like many theories in finance and economics, the Efficient Market Hypothesis can be considered to be a half-truth. Super-fast technology exists so prices can mostly keep up with real-time information, but human psychology and beliefs are also inherently involved. Until we can come up with a perfectly realistic model, we can acknowledge that the market may not be perfectly efficient, but it is to a good degree.

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