Efficient Market Hypothesis Made Easy

Summarized Overview

1. What is efficient market hypothesis.
2. Arguments related to this theory.
3. Type of formation, and which formation is best describes your local stock AND market scenario.

Concept and Definition

Secondly, efficient market hypothesis allows that when faced with new information, some investors may over react and some may under react, you can call it as extreme optimism and excessive pessimism if you want. And the investors' reactions are random and follow a normal distribution pattern. If this happens, the net effect on the market prices cannot be reliably exploited to make an abnormal profit. Thus, any one person can be wrong about the market; indeed, everyone can be, but the market as a whole is always right.

Confused? Let me illustrate further what is efficient market hypothesis is all about.

One day, a finance professor and his student came across a $100 bill lying on the ground. The student stops to pick it up, but the professor says, "don't bother. If it was eally a $100 bill, it wouldn't be there as someone should’ve taken it".

Arguments from Experts

After all, if the stock market is that efficient, investors cannot make exceptional profits either through fundamental and technical analysis. The reason is, any profits available would be spotted quickly and seized by other professional market participants. Simply put no bargains available to investors.

In an efficient market, it is not possible to consistently outperform the market by using any information that the market already knows, except through luck.
Nevertheless, some investors and money managers are convinced of the efficient market hypothesis. They do not believe that they can turn in a superior performance in trading a portfolio of securities. Therefore, they concentrate on buying companies with superior management. The business managers and owners are trying to maximize profits, attempting to make the company as successful as possible.

Efficient Market Formation

1. Weak Formation
   Situation: Stock prices reflect all the past information in prices. Thus, current stock prices are the best estimated value, provided no change to the company’s fundamental value. Fundamental analysis can be used to investigate if the stocks are undervalued or overvalued.
   Effect: no excess return can be made from investment strategy that based on historical stock price or financial information. Technical analysis method can be difficult to implement, but some fundamental analyst can still make some money in the stock market.
2. Semi-Strong Formation
   Situation: Stock prices reflect all past and current publicly available information. The stock prices can be adjusted in an unbiased movement to any new public information; e.g. on business news on local newspaper. However, the adjustment is relatively small.
   Effect: Not much gain can be earned by trading on this information. Though fundamental analysis can be useful, the returns are normally not as much as in the weak formation.
3. Strong Formation
   Situation: Stock prices reflect all relevant information, including data that is not yet disclosed to the general public such as insider news.
   Effect: Almost nobody can earn high return on investments over a long period of time.

The kind of market formation is depending on two things.



First is the market maturity. American and Europe stock market; which considered as matured enough, can be in the strong formation, whereas other developing countries, such as the Asian or African stock market, can be either in the semi-strong or strong formation.

Nevertheless, in this global economy, other developing market like India or China can be in very strong formation as well. This happens as their astounding growth attracts foreign interest to participate, especially from US fund managers, hedge funds as well as individual investors.

Second is the stock coverage among market players; especially media and stock analyst. High profile companies such as Google and Microsoft can be difficult to be exploited. Due to overwhelming response from investors and traders, media and analysts left which no choice but to keep them updated almost daily!

Any information or comments easily leads to changes in their stock price. Therefore, it is your task to discover the hidden gems that are yet to be advertised by media. Some called it, “the next Microsoft”.

What you Should Do Now

Look, most of the stock markets around the world are semi-strong to strong formation. Therefore, investors who have more knowledge than the rest can make exceptional gains either through fundamental analysis, technical analysis or even speculative trading (insider information). This is exactly why, you need an investment knowledge, right? Not just to make money in the stock market, but create wealth out of it! If you believe in the efficient market theory, you wouldn't trade that often. However, the best money making opportunity for you is buying when the stocks in undervalued; or when most investors are very pessimist, and hold them as long as it is profitable. But if you are not, you tend to trade that often, hoping to catch the efficiency gap all the time.

Benefit?
You might get as much profit (or losses) as possible.

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