Subscribe to Entrepreneur for $5
Subscribe

The Efficient Market Concept Is Wrong But Not Absurd

It’s the idea that the stock market is efficient that started all the trouble. Q3 2021 hedge fund letters, conferences and more If no one had ever thought of that...

By
This story originally appeared on ValueWalk

It’s the idea that the stock market is efficient that started all the trouble.

mohamed_hassan / Pixabay - Valuewalk

Q3 2021 hedge fund letters, conferences and more

If no one had ever thought of that one, we all would have been market timing all along. In every other market that exists, people buy more of the thing offered for sale when it is priced well than they do when that thing is not priced well. So why doesn’t that rule apply for stocks? It’s because there were people who said that the market is efficient. If that were so, stocks could never be mispriced. So there would be no need for market timing and it wouldn’t serve any good purpose.

The Concept Of Efficient Market

The market isn’t efficient. That’s why stock investing is so messed up today. For the market to be efficient, investors would need to be 100 percent rational. And of course they are not. Market timing is the thing we turn to when our emotions get out of control. We see prices getting too high and we lower our stock allocations in response and that pulls prices back down to reasonable levels. But, if the market is efficient, there’s no need. So things just go haywire.

The market is not efficient. That idea that it is is a very wrong idea and a very dangerous idea. But it is not an entirely absurd idea. People’s financial futures depend on getting stock investing right. So you would think they would put a good bit of effort into getting it right. The market really should be inclined toward efficiency.

It’s the belief in efficiency that has caused us to fall so short of the mark.

Think of what would happen if we told people that, no matter what they ate or how much of it they ate, they would never put on excessive weight because it would not be rational to put on excessive weight and therefore it was impossible to do so. That’s what we have done in the stock investing context. When we tell people that the market is rational, we are telling them not to worry about trying to be rational. Which increases the level of irrationality to its highest possible mark. Hence, today’s CAPE value of 40.

Efficiency/rationality should be a goal, not an assumption.

Market Timing

I am a big advocate of market timing. The market finds the right price level by testing different levels and by investors responding to those price points with either sells or buys. When investors are discouraged from market timing, they do not respond effectively to the market’s efforts to identify the proper price. So nothing works.

The great irony is that, in a world in which investors were encouraged to engage in market timing, it would be rare for circumstances to develop in which much market timing was required. A fluid market -- one in which investors respond to high stock prices by selling stocks -- is a self-adjusting market. Prices never get too out of whack in such a market. A market in which most investors don’t appreciate the need to engage in market timing is a market in which prices can just increase and increase and increase until they get so high that they crash violently. Failing to encourage market timing increases price volatility dramatically.

Efficiency/rationality is something that we have to work at. We all want to be rational investors. So it is not absurd to think that the market could come to evidence a high amount of rationality. But we also possess Get Rich Quick urges that threaten to cancel out our desire to be rational. Rationality can win out if investors battle for it faithfully every day. But to declare the market “efficient” before any effort is exerted to make it so is to forfeit the game. Complacent investors do not make efficient markets. Price-indifferent investors get pulled by the ocean’s tides into creating highly emotional markets. Efficient is earned, it is not automatic.

I believe that we will see more efficient markets in future days, days in which market timing will not be something that is disdained or even grimly tolerated but something which is widely and effusively welcomed and encouraged. An efficient market is a well-run market. We are not there today, we are not even close to being there today. But we should not give up on the dream. Market efficiency can be achieved if we work it hard enough.

Rob’s bio is here.