Is the Stock Market Efficient?

by Prem C. Jain, Ph.D., CPA

Few people consistently make money betting on horse races. In finance terms, the horse racing market is efficient. But is the stock market efficient?

Some people argue that the stock market is efficient and that you should not spend any time trying to beat the market averages. On the other hand, others, including Warren Buffett, argue that the market is not efficient. It is not productive to debate whether the market is efficient; the important point is to think about the extent to which it is efficient. We come across many questions in our lives when a simple yes-or-no answer is not very meaningful. When someone asks, “Am I going to be able to make a living if I study engineering?” or “Am I going to get a job if I have a degree in mathematics?” the correct answer is generally “Yes, of course.” However, it is more important to know how good a living you can expect to make if you become an engineer or what kind of job you can land if you get a degree in mathematics. In the same manner, a simple yes or no to the market efficiency question is not worth getting agitated about. It is more important to know how, when, why, and to what extent the market is efficient and, especially, how, when, why

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Prem C. Jain, Ph.D., CPA is the McDonough Professor of Accounting and Finance at the McDonough School of Business, Georgetown University, in Washington D.C..


Edward from Pennsylvania posted over 2 years ago:

It is interesting and on point.

Jim from California posted over 2 years ago:

Jain's book is an excellent source of priceless information that many of us know, but for some reason don't apply. Using some of his ideas, my portfolio has survived the "great recession" very handily. Thanks, Jain.

Michael Shideler from Idaho posted 6 months ago:

"First of all, since most money managers do not beat the market averages, it should be clear that you should not listen to most money managers."

The big issue that I have never really seen addressed in any article about how most managers fail to be the markets as a measure to evaluate the managers is this - managers often have pretty hard and fast rules as to what they can invest in and how.

They also have to deal with inflows that have to be put to work, almost always as the market is climbing thus their cost basis is almost always being increased because they have to invest when they, personally, might believe their options to be over valued and they would not personally add money to the areas that they have too.

Then, on the downside, they have nearly the same issues just put into reverse. In order to meet demand for cash (out-flows) beyond the cash that they normally sit on they are forced to sell some securities and thus, sometimes creating capital gains that are taxable for many investors along with selling things on the way down. Would the money managers that have to follow the rules of the funds that they run sell their personal investments during a pull-back or, perhaps, shift cash to undervalued areas in order to take advantage of opportunities that arise from market fluctuations.

So, 1) beating the indexes is not hard since I have no rules I have to follow nor do I have share holders making demands for cash out or to invest money that they desire to pour in.

2) managers not beating the indexes is, for lack of a better term, a false argument since they have stacks of rules within the funds that they manage and have to follow.

3) money managers sometimes have to deal with hundreds of millions or billions of in-flows and out-flows. As an individual investor, I can sell a few thousand shares of stock in 1 second without impacting the price of the security. When you are talking about trying to buy or sell hundreds of thousands or millions of shares of a stock you cannot just buy or sell without impacting the supply / demand for the stock and thus the price. Sometimes they have to spend days or weeks building a position. Individual investors - in or out in seconds.

Even Buffett has stated that if he had a million dollars he could perform much better than he does now. At a certain point just the size of the dollars involved will begin to reduce possible gains.

William Brown from California posted 5 months ago:

Position size as well as due diligence doesn't mean you should or have to attempt to time the market. I'm not a full time trader, nor do I have as much exposure to market indices as a full time trader attempting to hedge across various sectors. I think I was taught this a diminishing returns also. Good topic as always!

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