Economics on the small scale

Friday, May 19, 2006

The Efficient Markets Myth

There is a Myth that all available information that could affect The value of a given stock is instantly reflected in the price of shares for that stock and therefore the Stock Market is a efficient means of determining the correct price for stocks.

The idea is that Wall Street (and to a lesser extent: Main Street) has lots of really smart people paying attention to these companies and competing in trying to figure out how to make money buying and selling shares of these public companies.

The instant new information became available, the theory goes, one or more of these really smart people would figure out how this new information will affect the company's financial future and buy or sell shares until the price is back in balance with the company's actual value.

Now, this makes a lot sense, and I've no doubt that this scenario actually occurs on a daily basis on Wall Street. But does that mean that this makes the Stock Market as a whole an efficient means of determining the price of any given share of any company ?

I don't think so.

Figuring out the future is hard; a gamble really. What happens if the smartest analysts mis-interpret the data and buy when they should be selling ? Or end up buying at too high a price, or sell when they should have been holding ?

(the best case scenario for them is that they make less money than they could have, but they still make money).

The not-as-smart analysts are going to make worse errors in how they interpret the data, though through sheer dumb luck some might stumble onto the correct price [range?] occasionally.

Now let's back up a little bit. The not-as-smart analysts are still in the game to make money and if their own analysis isn't cutting it, maybe they can ride the coattails of the smartest analysts by mirroring all of their transactions.

Now, if you're one of the smartest analysts, those not-as-smart analysts acting as parasites on your work could be another potential source of profit if you can get them to take positions that you can cash in on. Figuring out how to con the greedy and the lazy is easier than figuring out the financial future of some very complicated companies or even simple companies whose financial future hinges on fortune's favor.

If the smartest analysts engage in that game, who can glean whose gains were got from where ?

Are there actually really smart analysts paying attention to all the data that could affect the financial future of each and every single major publicly traded company ? There are probably thousands of professional analysts for each of the Fortune 500, but how many are there for each company in the next 5000 major companies ? Are they all as high in quality? Are they watching all the relevant data ? All of the time ? Are they all in a position to act on their analysis in a profitable way ?

What about non-professionals who buy and sell with only the most cursory of analyses (if any) and laxest of discipline (if any)?

But even the smartest analysts aren't constantly alert to information that may change the future, they won't be able to always correctly predict the data when they get it, and if they had the incredibly vast resources necessary to play the stock market in this way, they wouldn't need to put in the necessary effort at analysis to make serious money, they could just skim it off of the top.

The bottom line is that Stock Markets aren't all that efficient for determining the value of a given company. Some companies, particularly the Fortune 500, maybe, since that's where the money is. But maybe not even then as it's hard to figure out what the future may hold.

The Moral is that if you let the Efficient Markets hokum theory deter you from doing your own analysis of what the value of a company is, and therefore what its stock price should be, you're likely to get taken to the cleaners.