What does ‘efficient market’ mean?

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‘Efficient market’ is one of the most important terms to understand when it comes to investing. It’s important because what you think about the efficiency of the market will dictate how you practically invest your money, which will shape your retirement and legacy.
So first, what does it mean? If the market is efficient it means that stock prices react to news and information really fast. For instance, news breaks that a company has committed fraud, and the stock price of that company falls immediately. It also extends to any small bit of news or public sentiment regarding the market or specific companies. Market prices are always moving based on new information and perceptions, and they move almost immediately upon receiving that new information. Those are signs of an efficient market. The speed at which information travels today has only made the market more efficient.
So why does that matter? Well, if the market really is super efficient, it means that picking stocks is futile. Think about it, if the market prices react and update immediately upon receiving new information, the only thing you can do to beat the market is to guess right. Unfortunately market guesses are less like investing and more like gambling. So if the market is efficient, the entire way you’ve previously thought about investing is not only impractical, it’s basically a roll of the dice. Instead of trying to beat the market, an efficient market would suggest you own the whole thing as efficiently as you can. You would diversify and hold stocks instead of research and pick stocks.
There is another important thing to recognize about investing in relation to the efficient market: people do beat the market sometimes, they sometimes pick the right stocks and get better returns than the market as a whole. It’s not often, somewhere around 90% of stock pickers underperform the market every year, but that leaves around 10% who seem to be doing something right. That 10% either figured something out, found some inefficiency in the market, or they got lucky. The thing is, it doesn’t really matter if they’re smart or lucky, and there’s not really any way to empirically test it anyways. Because the market is efficient, if a smart person does find an inefficiency it will close up before long, and if a lucky person gets lucky, they’ll also get unlucky at some point. Either way, by the time you’ve heard about their success, it’s too late. People who have beat the market in the past are much more likely to underperform the market in the future than to beat it again. In fact, they’re more likely to underperform even their contemporaries in the future. Any way you cut it, in an efficient market it simply doesn’t make sense to try to find or profit from market inefficiencies, regardless of whether or not they really exist, or to what extent.
So if the market is efficient, to whatever degree you agree, don’t try to beat it. Instead, own the efficient market as efficiently as possible.

Part 4: Conclusion

All of the information used to identify where returns come from is historical data. The data shows us how asset classes behave relative to each other (correlation), how much risk (volatility) is associated with each, and how much return we can expect over long periods of time.

But, it’s important to distinguish between what history can and cannot show us. While historical data does show us how the market works and how we can be ideally diversified to capture returns, it does not tell us which specific stocks or asset classes will be up or down from year to year or anytime in the future. It’s popular practice to analyze data and trends in an attempt to predict what the market will do next, many investors even expect that type of prognostication from their advisor. The problem is that humans simply can’t predict the future. As much as we like to think we can beat the market, the best we can hope for is to guess correctly, which is much more like gambling than investing.

Based on what we know about the market, we can capture amazing market returns with some discipline and patience. We know the market is efficient so it’s useless to try to predict or beat it (part 1), we know we can reduce risk and increase returns with strategic diversification (part 2), and we know that certain asset classes outperform others over time (part 3).

By understanding and putting these principles to work as an investor, you can stop stressing, stop guessing, and let the market grow your money.

Instead of making a guess as to what the market will do next year, put yourself in the best possible position to capture the returns it will offer, whichever sector they come from.