Efficient Market Hypothesis
The market is efficient and this phenomenon is explained by the Efficient Market Hypothesis or Efficient Market Theory. The efficient market hypothesis asserts that financial markets are “informationally efficient” or that all relevant information is known and factored into the current price of the underlying. As a result, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given theinformation available at the time the investment is made.In other words, for an average investor, if you think you are taking advantage of a stock because you have some information, it is probably already priced in.
Together with the Random Walk Hypothesis, this is also against the believe of value investors who studies the financial statements (or fundamental) of an underlying and buy into it thinking that the market hasn’t discovered the “true value” of that particular underlying. The efficient market hypothesis also contradicts technical analysts who love trends and believes that the trend is you friend. Basically thinking that you know something that the market don’t already know, is against the efficient market hypothesis.
Nobel Prize
The Nobel Prize in Economic Science 2013 were awarded to Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen “for their empirical analysis of asset prices“. Basically for proving their case for the random walk and efficient market hypothesis.
Why do I believe in the efficient market hypothesis?
The efficient market hypothesis is often debated. However, when you have an underlying that has a lot of liquidity, with the bid and ask only one or a few cent apart, how is the market not efficient? When there’s a buyer, there is always a seller out there willing to take the other side of the trade. Vice versa. With this reasoning, I can’t argue against the non-existence of the hypothesis.
My believe is that the market is priced correctly. Whatever the price it is of an underlying reflects the value it is at that particular moment. It might be over extended during a rally or a sell off, but the price is what it is. There is no edge at all if you think you know something that the market doesn’t already know.
Having said that, I only believe the efficient market hypothesis to a certain extent. I don’t believe the part where it states that “one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis”. I think that individual investors CAN beat the market.
Discounting The News
News are irrelevant to me. If you believe in the efficient market hypothesis, news would be irrelevant to you too. Learning about the financial market, a piece of gold advice being handed out on a regular basis is to ignore the market noise. What is “market noise”? It means everything news, the adages that have no statistical prove behind them and the common traditional belief that everyone believes in that doesn’t work etc. So stop bothering about what Bernanke is going to say or guess what the Feds are going to do next. 1. You wouldn’t know what they’re going to say and 2. you wouldn’t know how the market is going to react to the news. It doesn’t help you at all! To me, news only provides trading opportunities, nothing actionable in itself.
Tapering News
There have been talks and guesstimates that the tapering from the Federal Reserve will begin early next year (this was written before the slight taper itself). Just like this analyst, many analysts remain bullish and advises to buy because the market will only sell off when the tapering starts right? But, is it really that obvious? Buy when the bell goes on and sell when it goes off. Of course not! Just look at the bonds. Bonds should only go down when the tapering starts isn’t it? But many people who bought bonds are now trapped because bond sold off from 150′ to 130′ without any bell going off.
Anyhow, the tapering has begun yet the market is going higher! Crazy bubblicious!
Probability
Bringing the topic back to efficient market hypothesis, people who believes in it understands that they know nothing about the market. So if I were to refer back to the forex shot that Johnathan took in the Random Walk Theory article previously, it was really a 50-50 shot. Or for pure buying or selling of any stock for that matter. I would argue that they are nothing more than a 50-50 shot. The stock can only go two ways, up or down, Considering that the market is random and efficient, it’s a 50% probability trade, a la flipping a coin. Very soon, I’ll be going through one of the simplest options strategy that’ll make so much sense to any investors and maybe even change them into trading a little bit of options too. Who knows.
Conclusion
As far as my trading is concerned, I believe that the market is efficient (but we can beat it) and random. The takeaway here is to Ignore the market noise and whatever insider news (who bought what and whatever) or whatever you think you know that the market doesn’t already account for. This saves a lot of time and energy because the news aren’t actionable anyway.
What can be learned are strategies to put on in different market conditions to put yourself in the best position and hope the market accommodates. It is through this strategic allocation, and statistical backing that traders think they have the ability to, and some actually do, beat the market consistently.
Hope you have learnt a lot, please leave your comment and share it with your friends.
Thanks
Trader Pok
P.S I’ll be setting some New Years resolution in the next post.
The post Efficient Market Hypothesis appeared first on Options Rising Star-.
