Efficient Market Hypothesis: Do Under Priced Stocks Exist?

In an efficient market, the asset prices reflect all of the available information. The idea is that it is impossible to “beat the market” consistently, since the market only updates its prices based on new information. Put differently, stocks always trade at their fair value on exchanges, and investors can never buy “undervalued” stocks or sell them at “inflated” prices. Therefore it should be impossible to outperform the market through stock selection or timing the market, and the only way to get higher returns is by purchasing risky investments.

I’ll begin by noting that the efficient market hypothesis (EMH) is highly controversial. Those who believe in it argue that it is pointless to search for undervalued stocks or try to predict market movements through analysis. Since stock prices reflect all the available information, the best move is a low-cost, passive portfolio. But Warren Buffet exists. He is just one of the many investors who have consistently beaten the market over long periods. That should, by definition, be impossible — according to the EMH.

The EMH argues for passive investing. You buy and hold a low-cost portfolio, and those are you best hopes for the best returns. This is even more promising when you realize that actively managed funds — where investors sit day in, and day out, trying to predict market trends, staring at computer monitors and buying and selling shares — perform worse than passive funds in most categories. From 2009 to 2019, only 23 percent of active managers were able to outperform passive peers. In general, investors who invest in ETFs fare better.

The reality is that the EMH in its purest form is wrong. Some markets are demonstrably less efficient than others. That is, asset prices don’t always accurately reflect their true value. This happens for various reasons, among which are human psychology and emotion, as well as transaction fees and the presence of buyers and sellers. Most markets are, in one way or another, inefficient. Otherwise investors like Warren Buffet, who has made billions buying undervalued stocks, would not exist. The response of EMH proponents to Buffet’s wild success? Sheer luck. Sounds like somebody is jealous.

Real-life implications of EMH:

• Earnings Announcements: a publicly traded company releases its quarterly financial report. Within minutes of the news, the stock price adjusts to reflect the new data. Analysts who predicted an earnings beat or miss quickly see whether their forecasts were validated. In this case, the market is highly efficient — public information rapidly affects the stock’s price.

• Economic Data: the government announces new employment figures and inflation data. The financial market, including stocks and bonds, react almost instantaneously. The speed and scale at which these figures reflect prices demonstrates how public economic factors are incorporated into market valuation.

• Arbitrage Opportunity: an arbitrageur might notice a temporary price difference for the same asset on two different exchanges. They buy at the lower price and sell at the higher price, but this activity quickly subsists as other traders follow suit. The rapid elimination of price discrepancies underscores how markets quickly correct inefficiencies.

• Tech Bubble: during the dot-com bubble, tech stocks were overvalued based on hype and skewed expectations. As earnings reports emerged, prices dropped rapidly. Even during the bubble’s peak, some companies saw their stock prices plummet right as concrete data was released that contradicted optimistic forecasts.

How you might use EMH as a mental model: (1) be a realist — accept that consistently beating the market is very challenging, and that diversification and risk mitigation is going to be your main strategy instead of predicting short-term market shifts; (2) be a passivist — if you subscribe to EMH, consider low-cost index funds that generally mirror the market for slow, yet practically guaranteed, gains; (3) criticize the market — use EMH as a baseline for evaluating how effective the market is and how tangible expert advice is, as if the stock prices already reflect all the available data, be cautious about claims of “secret” insights or strategies; (4) win the waiting game — emphasize long-term investments, since short-term price fluctuations are rarely predictable and largely random.