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Capital Market Efficiency & Price Behavior

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  • 0:04 Efficient Market Hypothesis
  • 2:37 Forms of Market Efficiency
  • 4:28 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Information is a valuable commodity in investing, but in the modern stock market, information is easily available. In this lesson, we will review the efficient market hypothesis and how information availability explains market price behavior.

Efficient Market Hypothesis

Joe is having a discussion with his financial planner about the merits of investing in mutual funds as opposed buying single shares of stock. His planner suggested that a problem with investing in single stocks is that the market is already efficient, and Joe has no special ability to get a good deal that outweighs the risk of buying single stocks. Joe's financial planner is a believer in the efficient market hypothesis. Let's take a look at what exactly this concept describes about market prices a bit more clearly.

The efficient market hypothesis, or EMH, says that stock prices in the market are accurately valued because all participants have equal access to information. Any and all information about a company is readily available to investors through the Internet. Joe is thinking about buying shares in a movie production company the week before the latest summer blockbuster comes out. He figures that the movie will be a hit and the stock will go up. According to EMH, Joe doesn't have some unique or special insight into the stock; other buyers and sellers have already brought the market price of the stock to where it should be based on performance expectations. In other words, Joe isn't alone in thinking the movie will be a hit. Investors have already arrived at a fair market price for the stock based on expectations of what it might do in the near future.

To contrast, let's look at real estate, which is an example of an inefficient market. If Joe knows his neighbor is about to get foreclosed on, he might be able to buy that house at a discount, since he can offer enough money to allow his neighbor to avoid a foreclosure while still paying less than if the house were on the open market. The market is inefficient because there is a tremendous amount of information that isn't publicly available; an investor with more information is in a better position to choose a deal.

It is a misconception that the efficient market hypothesis depends on the idea of investors always behaving rationally. 'Rational' in this context means acting based on well-researched factual information instead of emotional buying and selling motivated by greed or fear. The reality is that EMH allows investors to behave with some degree of irrationality. Even in periods of fear and greed, such the events surrounding the 2008 recession, the variations caused by irrational trades do not affect the price valuation enough to give anyone a truly competitive edge in the market. Over time, the performance of the market will smooth out so that the exact purchasing timing doesn't give him an advantage over some other investor trying to pick the perfect purchase time.

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