American economist Eugene Fama is known for writing a dissertation explaining a theory called Efficient Market Hypothesis (EMH), according to which all the available information about an asset is reflected in its price. As the quality and quantity of this information increases, asserts Fama, so does the efficiency of the market.
By way of appreciating Fama’s theory, consider the fact that, when a company’s shares used to be included in the S&P 500 index for the first time, the prices of those shares would surge. After this phenomenon grew well-known, however, it largely stopped occurring. We see then that, as new information spreads, the market is efficient enough to absorb that information so that, as a result, the asset’s prices then remain unmoved by the further emergence of such info.
Consider also that companies’ earnings reports used to exert a greater impact on their share trading prices, until a law passed back in 2002 necessitated a higher level of transparency for any publicly traded company. Again, we see that the stock market efficiently absorbed an expanded array of information so that prices could stay steady from then onward.
For readers interested in CFD company share trading, but also in CFD trading with the prices in any other financial market, we’re going to explain some of the main arguments, both in favour of and against, the theory that markets are efficient.
Problems with the Theory
Some of the problems theorists find with Fama’s theory might have occurred to you already. Since, in fact, we see that stock markets do crash on occasion, and that “bubbles” in the market do surface from time to time, the reality seems to be that shares can be overvalued. One reason they can is quite apparent: human beings are the ones doing the trading, and they are driven by emotions and not just pure logic. Another reason is that information is actually not available to all market participants equally and instantaneously.
Take as an example a well-known tech company like Netflix. If they released a film that represented historical events inaccurately, the result would probably be a swift drop in their share prices. But if a much smaller company – one less covered by the media – were to be caught out on the same score, it could take days for the issue to reflect in share prices. An opponent of Fama’s would point out that, although the market reflects available information eventually, when and how much it does actually varies a lot. So, is there really any value in insisting it is efficient?
The existence of people like Warren Buffet also seems to contradict EMH. How would Fama explain the phenomenon of people who time-and-again achieve better returns on their money through share trading than would be offered by an index fund? In Fama’s world, there shouldn’t be any way to “beat” the market, since the market such an effective data absorber.
Defences
Some analysts jump to the rescue of EMH by pointing out that Fama never said an asset’s share trading price cannot shift away from its true price. In fact, he would admit that a share’s price at any given time does not necessarily reflect its true value. What he does believe is that you won’t be able to consistently figure out the future price movements of assets like stocks or share trading.
Fama doesn’t naively hold that all market participants are rational and computer-like, either, these analysts explain. Rather, he says that asset prices will eventually come to represent all the information that was available to traders. How long this will take is indeterminate and variable.
Looking to the future, we see a trend that might make Fama’s theory much more appealing and relevant. There is now the advent of electronics designed to analyze all the information surrounding an asset, using both fundamental analysis and pure mathematics. Computers can achieve even more and translate all this data into a succinct piece of trading guidance for users to take and run with. From that point on, however, their decisions are theirs to make, and no outcome is ever guaranteed no matter how sound the theory. If this technique were to become a lot more commonly used, perhaps financial markets would become much more efficient in the way Fama suggests.
Summing Up
This interesting discussion is made even more interesting by the way information is becoming more and more easily available to people all around the world as the months go by. In terms of computerized share trading, who knows the levels of efficiency this technology could achieve in coming years? It’s feasible that it could change the face of financial trading in many ways.
One thing financial traders do take from Fama is his perception that, when a one-of-a-kind and easy opportunity to succeed appears to present itself in the markets, the reality often turns out otherwise. For those who engage in share trading via CFDs, market information is everything, but always remember to trust only that which you have discovered and understand yourself.
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