The Efficient Market Hypothesis is a very important bit of research. It began when a man named Eugene Fama wrote his doctoral thesis in 1965 stating that markets are efficient. Here’s what ‘Efficient Market’ basically means: the current price of a stock is the right price (it’s not underpriced or overpriced) because all of the available information (news) has already been accounted for in that price. Let’s break down what that means for us:
- It means that past prices and movements of stocks have no correlation to future prices and movements of stocks. If the price is always what it should be, there’s no way to predict how the stock prices will move in the future (even based on trends and charts) because we don’t know what the new information (news) will be in the future. Even if you went deep and did a study on a few companies, you still wouldn’t have anything better than a guess for how the stocks of those companies would perform because those stock prices already reflect the information you studied, and you don’t know what new news or information will come out tomorrow to affect the price. Basically, the Efficient Market Hypothesis means people can’t predict the stock market because people can’t predict the future. That’s not to say that no one ever predicts the market correctly, but that when they do it’s a facet of chance, not the ability to tell the future, and it has never been done consistently over time.
- It also means that there’s no benefit in trying to capture better returns than the market offers (which, over long periods of time, are really great). If the market is efficient, instead of trying to outperform it by actively buying and selling, guessing which market sectors are poised for growth, or indulging in any other prognosticating efforts, we should focus on capturing the returns that the market offers as efficiently as possible (that ‘efficient’ word just keeps popping up!). We do this by strategic diversification (owning a large number of different stocks) and regular rebalancing (making sure you keep owning the same percentage of the different types of stocks). Free markets grow, they offer amazing passive return over time. We simply capture the returns by owning the market.
We mostly hear prognostications on the news. The default mindset in the media, and for most of us, is that we need to find the right stocks, the right market sectors, buy in at the right time, get out at the right time, and that’s how you make money in the stock market. But, since none of us can consistently predict the future, our default investment strategy essentially amounts to gambling. Great returns don’t typically come from gambling. In fact, all of the data suggests that the gambling approach vastly underperforms compared to the market over time.
The Efficient Market Hypothesis shows us that returns don’t come from an active investment (gambling) strategy. They don’t come from predictions, prognosticating, timing the market, or any type of strategy that requires you to know the future. Returns come from free markets rising over time. So we can stop stressing! No more guessing, no more betting, no more timing, we can own the market and let the market do its work.
In Part 2, we cover how to best own the market.