TOP DRAWER ARTICLE

The Efficient Markets Theory
by
HL Carpenter

What is the best way to make money in the stock market? Buy and hold - or buy and sell?

The debate may never reach a conclusion. Arguments abound as to whether markets are efficient or not – and your personal opinion about which theory is correct will influence your investing style.

What’s an ‘efficient’ market?

The Efficient Markets Theory (EMT) suggests stock prices reflect their true worth, all information is timely, and any future possibilities, though random, are accounted for.

This scenario seems to imply anyone can buy and hold or buy and sell because everything is as it should be.

Put another way, markets function with a minimum of waste, expense and unnecessary effort. Therefore, you might as well choose whichever method of investing makes you happy because the only way to ‘beat’ the market is if you get lucky.

The EMT, introduced in the 1960’s in an attempt to explain how capital markets work, has been controversial at best. Some believe the logic behind efficient markets means no one needs a stockbroker. Or, in the case of mutual funds, the fund manager is irrelevant.

The other point of view is less sanguine. That is, all present knowledge is not immediately available, a company’s stock price doesn’t always accurately reflect present worth – and, given human greed (frequently supported by news stories), insiders do use knowledge they’re privy to.

So what’s the most productive way to reap rewards in the market, passive investing or day trading?

In the final analysis, the truth probably lies somewhere between the two extremes: Markets may be efficient, but there can still be opportunities to profit. Making sure an investment strategy suits your risk profile and long-term goals can put you on the path toward reaping those rewards.

Originally published July 2004.

Last update: January 8, 2011