The efficient-markets theory is a very influential conjecture in economic theory that states that price fluctuations reflect all feasible information about the future activity of the market economy. This conjecture has some influential followers all over the world, though most experts do not believe it to be true at all times. However, there are still many people who subscribe to this theory as an explanation of how the economy functions. A further implication is therefore that it’s impossible to “beat the markets” on a risk-free basis, as market prices must always respond to new information arriving in the market.
This argument of course is circular. Why should it be true that it’s impossible to predict market activity accurately and consistently? There has to be some other force that keeps the asset price movements in the first place. Otherwise, it would be possible for you to successfully trade any time, with any type of asset, and make money consistently. Market movements cannot be predictable by anyone. That means it’s more accurate to say that no one can predict market activity reliably and consistently.
Now, let me get back to my original point. If no one can predict the movement of prices accurately and consistently, then it would follow that predicting the behaviour of the market is essentially impossible. It follows that everyone receives the same information, about which everyone can effectively act, which means that the efficient markets hypothesis states that everything stays in equilibrium. This is the most accepted version of the efficient markets hypothesis in economic theory.
However, many investors and traders disagree with this account of reality. They believe that markets aren’t self-stabilizing. They believe that markets are prone to chaotic and unpredictable behaviour, with highly contingent influences on future activity from all sides. For example, suppose that a securities regulation affects the price of a company’s stock. Now suppose that another regulation, perhaps concerning accounting rules, causes the stock price of that company to fall.
Both of these situations will have a negative impact on the price of the stock. However, only one of them will have a major negative impact – if the information available to the participants of the efficient market considers that the regulation causing the fall has been passed by the relevant authorities. That information will cause the markets to reverse, and the asset becomes undervalued once again. The participants who bought undervalued assets receive a large loss, and the firm with the undervalued asset becomes overvalued, and consequently they too suffer a loss.
Now this scenario is clearly a nightmare for the investors who expect market efficiency. However, what do we think of the situation where no information is available about any regulations? That’s right – no information! If there was no such thing as efficient markets, then what would be the point of investing in them?
Markets are never perfectly efficient, because they exhibit random sampling of market prices by individual participants. This means that there will always be a deviation from the true value, although it may be difficult to observe. A perfect equilibrium cannot be achieved because even the best and most technically perfect method on earth will not be able to achieve true value. Hence investors should not lose sleep over deviations from the true market price, but instead keep track of deviations from the mean value of the portfolio.
We know that the efficient markets hypothesis, in the form of a portfolio balance, is not an unbiased way to allocate assets between firms. We also know that changes from the mean of such portfolio balances will affect investment risk. But do not worry too much. We have algorithms which take care of allocation problems, within a strictly specified time frame. These algorithms treat portfolio balance as a relevant information source, rather than a fundamental guide to value creation. And we make sure that the algorithms reflect all the relevant information about the economy.