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Understanding the "Efficient Market Theory"

The efficient market theory, or EMT, as it's often referred to, is a theory suggesting that all available information about a stock is known and factored into its price. Thus, an investor shouldn't be able to find undervalued or overvalued stocks. There are strong and weak forms of the theory, and it's not embraced by all. Many Fools tend to think that the market is generally efficient, but there are still occasional pockets of inefficiency that an alert investor can take advantage of.

The classic book on the subject is Burton Malkiel's A Random Walk Down Wall Street, which you can read about in this Rex Moore article. Rex has explained EMT nicely, saying that, " a nutshell, EMT proponents believe:

  • There is no way to consistently predict future price movements from past results.

  • All relevant information about a company is already reflected in its stock price, and the price reacts to any new information by adjusting quickly.

  • Because prices are so efficient, a blind orangutan throwing darts at a list of stocks has just as good a chance of beating the market as someone who puts hours of work into the process." (Malkiel uses "blindfolded monkey" in his book, but we like this example better.)

Here's a Post of the Day from our discussion boards that addresses EMT and an article that addresses bubbles and stock inflation. Bill Mann hammered at EMT in this article, as did this other Post of the Day. More recently, Rex Moore explained how to beat an efficient market.

Here's a snippet of Bill Mann's objections to EMT, from the year 2000:

"Dow was at 9700, and it is now, less than three months later, with the Nasdaq off 37% and the Dow up 11%. EMT has a great deal of merit to it, but it misses two key issues: private information, including those influential analyst recommendations that may or may not be 'on the level'; and emotions, which effect even the most stalwart investor at times.

"I fully believe that over the long run that the market is an accurate measure of the quality of underlying businesses. But what do these short-term moves mean? That Mr. Market's Zoloft prescription ran out?"

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