What's the Efficient Market Hypothesis?

It's been a tough time for many investors lately, and plenty are feeling the pain of beaten-down valuations in their stock portfolios. Could some of this be due to widespread overreaction in the stock market?

In this segment of Backstage Pass, recorded on Jan. 21, Fool.com contributors Jason Hall and Toby Bordelon discuss the efficient market hypothesis and volatility in the markets, along with some recent developments with Peloton. The exercise equipment company currently faces mounting challenges, including declining profitability, and recently announced a wide-reaching restructuring plan, layoffs, and a CEO change. 

Jason Hall: The way you get through it is just align your timeline to position yourself and that's your edge, is knowing when you need the resources. Make it three, five plus years, not three, five plus months, because then you're setting yourself up for failure. Toby, I know you've heard of the efficient market hypothesis.

Toby Bordelon: Yeah. I studied that in finance.

Jason Hall: Yes. Like 60 years old.

Toby Bordelon: Yeah. There's it's an old concept.

Jason Hall: It's basically been debunked. But the idea that the market immediately subsumes every piece of information and fairly and appropriately prices assets based on that information, it's partly true. The market's like a giant field. If you take a field and you scatter crap all over it, something is going to grow. That's how the market is, it soaks up every bit of crap that gets thrown into it.

We just don't know what is legit, good, viable news, information, facts, and what is just a turd that floated. We know and this whole Peloton thing is a perfect example of that. Yes, let's look at it over the past six months over the past year. This has not been the rapid grower that we expected. The hardware sales have declined sharply. There was a lot of expectation they would increase. Over the longer period of time, we should acknowledge that's happened. What happened yesterday was a scared market freaking out over something that turns out was probably overblown.

I think the reality is somewhere in the middle. I think their CEO did a great job of talking a lot of people off the ledge. But let's be real, they're going to have to throttle back their manufacturing. Maybe they're not going to shut it down for a week or a month or whatever, they're going to have to throttle it down. 

That's not good for a company we thought was going to be growing. But the point is, is the market will quickly react to that information. Ladies and gentlemen, you will never be the fastest runner in that race. You will never be the fastest runner in that race. There'll always be somebody that is in the door or out the door faster than you will ever be.

Don't run that race. What is your edge? Knowing when you need the money, when you need the proceeds and aligning yourself. I talked about that. Build things into your system, this is what I do. Maybe it's not right for everybody, build things in your system to slow your process down. When you make a decision to act, automatically add another market day before you can do it.

There's a stock that I've researched today. I like that stock, I want to buy it. I can't buy it today, I have a rule. I can't buy it before the next market day. It makes me stop, and it keeps me doing from dumb things.

The Activision Blizzard deal, I legitimately thought about selling as soon as the announcement came out. I decided not to. Right now it doesn't look perfect because the stock price has come down a little bit from where it had jumped to, but I was going to sell for less than a premium that Microsoft is willing to pay. That doesn't make sense to do that.

Do things to make your process slow down. Whether you believe it or not, you have emotions baked in. If you want to act quickly, you are doing it because of emotions. You're not doing it because it's necessarily the best thing to do when it comes to buying and selling stocks. It's made me a much less worse investor. Avoiding those unforced errors, and one of them is trying to do it too quickly. Toby.

Toby Bordelon: Yeah. Thanks for that, Jason. I don't know that I have anything to add to this. I had to laugh last night. I really had to laugh out loud when I think someone posted that in the Slack channel when we were talking about this. I was like, oh look at these note from John Foley, like, are you kidding me?

They're actually not shutting down. The whole thing was just not real. It happens. In terms of efficient market hypothesis, my belief from experience is that like you were saying Jason, the market does actually incorporate all information out there, but it doesn't do it right all the time and it has a hard time distinguishing between real and fake in a lot of cases, and that's even getting worse now with the internet. It's even worse than it was.

Jason Hall: When there's algorithms, there's computerized trading algorithms that are responding to headlines in milliseconds, right?

Toby Bordelon: Yeah.

Jason Hall: All they're looking to do is be the first in or the first out, they don't care whether the information is accurate or not.