Efficient Market Theory – Fact Or Fiction?

Dec. 21, 2013 5:45 PM ET
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Contributor Since 2011

Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for www.TheStreet.com and the StockCharts.com Top Advisor Corner 

Given recent volatility in the market and obvious over-reaction of stock prices on a daily basis, how can anyone call the market "efficient?"

The efficient market theory (also called the efficient market hypothesis) is the belief that the current prices of all publicly traded stocks reflect all publicly known information at the moment. In other words, prices reflect an inherent efficiency within the market. This may be a very comforting idea in academia where the theory originated (first posed by Professor Eugene Fama at the University of Chicago Booth School of Business in the early 60′s). But in the real world of investing and trading, most participants know that the market is extremely inefficient, irrational, and over-reactive. In fact, this reality is the basis for much of the active trading that goes on today. We continually see stock prices over-reacting to the news of the day, either overall or specific to a company. An earnings report that misses the estimates by one penny might drop several points in one session, only to bounce back in the following day or two. Likewise, an unexpectedly positive report may create an upside bounce, much of which retraces quickly.

The inefficiency of the market is the most obvious characteristic, and the one that presents the greatest short-term trading opportunities. The efficient market theory is somewhat cynical, posing the belief that because all current pricing is basically accurate, it is impossible to beat the market. Efficiency in this regard is only a theory, and does not really exist. It is surprising that this claim of efficiency seems to never go away, given the glaring evidence that contradicts it.

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