The MBA's Guide to the Stock Market : a Look at the Efficient Market Hypothesis

Many investors try to beat the stock market through searching for undervalued stocks that they think will increase in price. However, one prevalent finance theory, known as the Efficient Market Hypothesis, suggests that this search for undervalued stocks is for naught since all stocks are fairly valued. The Efficient Market Hypothesis argues that the stock market is "smart," so smart that all current information about the stock is known and is included in the price of the stock. Further, followers of the Efficient Market Hypothesis believe that all future information about the stock cannot be known by any investor, so that any future price growth of a stock is purely random.

These theorists, who include Eugene Fama, have completed extensive analysis on stock market returns to prove the Efficient Market Hypothesis. What they have found is that over time, the vast majority of mutual fund managers and other investors do not beat the overall stock market. (These learnings have brought on the less-scientific testing which shows that a monkey throwing darts at a dart board can pick better stocks than most mutual fund managers. These researchers suggest that instead of purchasing mutual funds or attempting to pick individual stocks on their own, investors use index funds which track the overall market or pieces (i.e. small-cap, mid-cap, large-cap) of the overall market.

The Efficient Market Hypothesis does have some interesting points to consider. Legally, all information about a company's performance must be disclosed to the public. It is illegal for insiders to trade based on non-public information, thus, in theory, it does make sense that the stock's price includes all publicly known information. The Efficient Market Hypothesis does remain controversial in business community because some investors do enjoy greater than average market returns. Each investor can (and will) interpret this information differently. Thus, what one investor will see as undervalued another will see as overvalued.

The Efficient Market Hypothesis research that has been completed around mutual funds is very interesting and should cause all investors to weigh mutual fund fees and performance before deciding to invest in a mutual fund (vs investing in an index fund). As far as choosing individual stocks, it is up to each investor to conclude whether or not they feel that they can adequately determine the value of a stock through using the company's current financial statements and through projecting what the company's future performance will be.