"We are not measured by the trials we meet -- only by those we overcome."
- - Spencer W. Kimball
May 7, 2013
Being Efficient
by Adam Smith

In the academic world of financial economics there is the commonly held belief that markets are efficient. What does market efficiency mean?

In general, market efficiency means that given certain assumptions, assets are properly priced. For example, you can look at all the past history of stocks on a stock exchange, develop all kinds of computer models on those stocks, and on average you will not get a better return trying to pick stocks rather than just buying a mutual fund that holds all the stocks in a portfolio and holding on to that portfolio.

Market efficiency states that all past or known information has already been accounted for in the current price of the stock. If that is true, then only future unknown (random) events move the stock’s price.

To understand efficiency, you have to know that there are three types of efficiencies that academics consider.

First is Weak-form efficiency. This level of efficiency means that you cannot gain excess returns looking at the past prices of a stock.

Next is Semistrong-form efficiency. This level of efficiency means that you cannot gain excess returns looking at any publicly available information.

The last is Strong-form efficiency. This level of efficiency means that you cannot not gain excess returns looking at any information, public or private.

Most academics think that efficiency falls somewhere between the weak-form and semistong-form. There has been a lot of research on past prices and they do not give you any advantage. Some investors spend prodigious amounts of time developing computer models that do a great job of predicting all the old stock prices. The future prices — not so good.

Also, all public information related to a company should be in a price. For example, if a company sells farm equipment and a story is released that farmers had a bumper crop with good prices, then you would expect the farm equipment company’s stock price to have a positive reaction.

Not many believers in Strong-form efficiency. It is too easy to think of counter-examples, such as a company that has developed something very valuable to the company but only a handful of people inside the company know about the breakthrough. The information is available to a few private individuals, but the stock price will not be affected until the information is released to the public.

Where there are possible excess profits is if you are smart enough to put seemingly unrelated events in the proper perspective and then act on that understanding before anyone else.

A good example was in the early 80s. Prior to the 80s, the money in the computer business was in the hardware. If in the early 80s you understood, as did Bill Gates, that the future was in software, not hardware, you could have become very wealthy. Alas, most of us are not Bill Gates.

Understanding market efficiency can help you identify silly things people say.

I was in a training class for my profession and we were being trained on a new computer tool to help us determine whether potential investments for our business would increase value to our shareholders and if it would increase value by how much. During the course of the day, one of the instructors decided to explain how market efficiency could not be correct. He personally knew of companies in the stock market that were not correctly priced.

This, of course, created a great deal of amusement for me. Based on what I have written so far, I hope the following questions come to your mind:

  • What type of market efficiency are you referring to?

  • What information do you have the public does not have?

  • What are you doing working when you should be fabulously wealthy if you can easily pick incorrectly priced stocks?

I heard a company’s CFO once say he was going to go talk to analysts about the company to see if he could increase demand for his company’s stock and thereby increase the price of the stock. He had no new information, just generally available information about the company that was obvious from the financial statements.

I went up and spoke with him after his speech and he did not seem to like my belief that just regurgitating known information was not going to move the stock price.

It is important for me to point out a few things that market efficiency is not.

Market efficiency does not suggest that no one makes a lot of money in the stock market. It does say that they person who made the money was likely lucky, not skillful.

Market efficiency does not say that all assets are always correctly priced. Remember those assumptions I mentioned at the beginning of the article. Some of those assumptions include interference from the government.

The housing price collapse of 2008 is a great example. The bubble in the housing market was created by easy money from the fed, ridiculous mortgage backing by the government, pressure by the government for banks to lend to those that did not traditionally qualify for loans and this led to sloppy lending practices, corrupt appraisers and bankers, and so on.

The next time you hear of someone spending their time trying to pick stocks, just smile, remember market efficiency, and be grateful that you are not going to spend your limited time here on Earth trying to be lucky in the market.

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About Adam Smith

Adam Smith is obviously not the actual name of the author of this column. The real author has worked for two Fortune 500 companies, one privately held company, and a public accounting firm. His undergraduate degree was in accounting, and he earned an MBA for his graduate degree. He also has completed coursework for a PhD. in finance. He continues to be employed by one of the Fortune 500 companies.

The author grew up in the Washington D.C. area but also lived for several years in Arizona. He currently resides with his family on the East Coast.

The author has held various callings in The Church of Jesus Christ of Latter-day Saints.

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