What Is Stock Market Efficiency?
Hello traders. Welcome to the stock trading course and the third module, ‘How the Stock Market Works’. In this lesson, we’re going to talk about market efficiency. Well, the overall goal of this course is to help you become a successful stock trader or a profitable stock trader. It really doesn’t matter if you’re a day trader or a medium-term trader, there are some things you really have to understand about the stock market before even start trying to trade.
Right now we’re going to talk about market efficiency, and I’m going to start by defining this term to you.
What is market efficiency? When investors make a trade, their goal is to generate a return on their capital. Or when you guys you make a trade, your goal is to close that trade in profits. Many investors try not only to make a profitable trade, but to also beat or outperform the market.
Why is that? Many investors or hedge funds try to outperform the market, because if they don’t outperform the market on a yearly basis for example, it’s easier and less riskier for their clients to invest in index funds than in hedge funds that have even been in the S&P 500. Investors try to outperform the market. Of course the U.S traders are going to try to outperform the market too because it’s easier for you, as traders, to just invest or put your money in an index fund if you can’t beat the market.
Now this course is going to teach you how to beat the market and how to be a profitable trader, day in, day out. Let’s start by understanding what the stock market is and its efficiency.
Market efficiency suggests that at any given time, price fully reflects all available information on a particular stock. According to this theory, no investor has an advantage in predicting a return on a stock or on a stock price because no one has access to information that are already available to everybody else.
In an efficient market, all the information is available to anyone at any given time. The price of the stock that we’re looking at reflects this information and most importantly, the price of the stock reflects how traders perceive this information. If they perceive it as good, price will go up, if they perceive it as bad, price will go down. This is an efficient market.
The nature of information and the effect on the stock or on the stock price. According to the efficient market hypothesis created by Eugene Fama in 1970s, prices respond only to the information available in the market and how market participates, perceives such information. Information is not limited to financial news but also to political, economical, and social events, as any information that will have an impact on the company or on the stock price.
In efficient markets, price becomes random so a planned approach to invest it cannot be successful. This is important. If you come to the stock market with a planned approach to invest in or trade in, you’re not going to be successful because of the market efficiency price are very random.
In reality, there are investors that outperform each other and the market returns every month and every year. Even with an efficient market, anomalies or patterns can be discerned to achieve superior results. Price in stocks sometimes might be over and undervalued, only to revert back to their mean values. This is what we look for in an efficient market, where all the information is available to everybody else to make better-than-expected returns on our investment.
What I’m trying to say here is that, in an efficient market where all the information is available to everybody else, prices are random. And I’m not saying that they move randomly, but they are random in the way that they reflect how the investors are perceiving the information available. If you go with a planned approach to invest in…and I’m not saying here that you should not plan your trade, of course, you should plan your trade, but you cannot plan an overall investing approach.
What we’re going to do here is in an efficient market, look for anomalies where stock prices are undervalued and overvalued. Why? Because in an efficient market, sometimes you will find these anomalies, and when prices are overvalued or undervalued, they will revert. They will go back to their natural price levels. We’re going to take advantage if this. We’re going to look for stocks that are undervalued or overvalued for investment purposes.
If you’re a day trader, this might not apply too much, but it’s very important to know what or how you’re going to be making money in the stock market.