The efficient market hypothesis holds that financial markets digest (and reflect) any information that might reasonably provide clues as to the true value of an investment so quickly that one cannot consistently outperform the market on a risk-adjusted basis.
In other words, under the efficient market hypothesis, market prices are thought to instantaneously reflect all available information. The end result is that all investments are fairly valued, and that any outperformance by an individual investor is due either to random chance or to the investor taking outsized risks.
Whether or not our financial markets are truly efficient, I’m convinced that they’re efficient enough that I don’t have the time, information access, or skill to outperform them. That’s why our portfolio is composed of index funds that seek to replicate the performance of the market while minimizing costs.
Today, while wandering around Disneyland, I was struck by the extent to which information flow begets efficiency. In case you weren’t aware, there are now smartphone apps available that allow users to share information on wait times at different attractions (see, for example, here).
Gone are the days when you could be mindlessly waiting for an hour to board It’s a Small World back in Fantasyland while others are enjoying ridiculously short wait times at Space Mountain up in Tomorrowland. You’re now never more than a click of the refresh button away from complete knowledge of what’s happening everywhere in the park.
This means that people will quickly discover and flock to “undervalued” rides, thereby correcting any wait-time inefficiencies. The same, of course, is true of financial markets. Investors (as a whole) are quick to react to any relevant news and correct the prices of undervalued (or overvalued) investments.
The point here is that information access begets efficiency. And information has never been more freely or quickly accessible than it is today.
The next time you think you have some great insight into the next big thing, ask yourself if it’s to think that you’re the only one with access to that information. Chances are it’s already priced into the market.
@Lance — Well, the lesson should that if most people are using the smartphone app there’s no reason for you to do it — because the lines everywhere will be at maximum efficient length (with some modifying factors like popularity, which will still mean longer queues for certain rides etc). A bit like buying an index fund! 😉
I know it wasn’t the point of the post but I’m definitely going to have to download an app like that next time I go to a theme park! I don’t mess with individual stocks because I don’t have the time that the professionals have to analyze everything. I think that a majority of info is public but most people just don’t know how to properly assimilate it. There is no denying that there is some shady stuff that goes on though.
I think it’s safe (and smart) to assume in trading stocks that everyone knows everything, all the time. People arrogant enough to think they have singular insights invariably end up losers.
Flexo: I think the key word in this post was “available.” I completely agree that there is a ton of information that isn’t available to the average investor. But what about the info that is available? To me, that’s worth little (if anything). After all, by the time that I know it, everyone knows it.
The more I know about the stock market, the less I know I know. The free flow of information that is presupposed by the efficient market hypothesis just doesn’t exist. Some entities are privy to special information, while the general investing public is not. The investigations into Facebook’s banker’s conduct will likely mean that the flubbed IPO will be a good example of this. The market might be efficient *enough* so that indexes are your best bet without access to privileged information and the means to trade on that information (for most of us, insider trading is illegal, but some seem to get around that), but the market itself is stacked against individual investors.
Most people have the overconfidence bias if they think they can outperform the market. Index funds should be the core of your portfolio. As you pointed out, the majority of people don’t have time to evaluate and they don’t have the tools.
This is very true but it should not stop you from investing in something if you really believe that in the future it’s going to be very big. The fact that information is so readily available certainly will reduce your profits because a lot more people will know about it but it’s still possible to make money on it in the long run.