Wednesday, March 11, 2009

Efficient market theory

You may have heard this theory a lot of times but what is it really about?

Efficient market theory states that it is impossible to beat the market on the long run because all the information available to investors is present in the price of the stock.

I must say that I tend to agree with this argument but there is a big if. The theory is assuming that human beings are rational and that before making an investment they make all the necessary analysis and as a result the price of the shares and any instruments will be a reflect the available information.

This theory however fails to take into account several things:

1. Investors are affected by greed and fear as a results in boom times prices are above the real price and in bust times they are below the real price.

2. Some sectors outperform the market while some sectors underperform the market. As a result investors that invest in these sectors will tend to outperform the market.

3. Following 2 above it can be suggested that because not every portfolio is diversified equally and subjected to the same risk coefficient. As a result some portfolio may outperform others and the market.

4. Some investors have preferential access to investment instruments like Warren Buffet because of their influence. As a result they also might outperform the market.

As you can see even though the Efficient Market Theory may be true in theory, the market is so volatile and unpredictable as a result it is not impossible for some investors to outperform the markets.

If i may say at last, I would tend to think that more would underperform the market than outperform it. So it is better if those that are just starting would stick to Index funds.

As usual if you disagree with me you can leave a comment below.

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