Benjamin Felix June 16, 2014 Market Research How efficient do markets have to be to make picking stocks a waste of time? Capital markets are a highly competitive platform where millions of buyers and sellers are able to weigh new information and voluntarily enter into transactions. In any transaction, there has to be a buyer and a seller; if there are no more buyers at a given price, the price will go down until more buyers emerge. The same thing happens in the other direction, and that is what makes prices go up and down. Market participants enter into transactions based on some piece of information that is influencing the buyer to think a security is worth more than its current price, and a seller to think a security is worth less than its current price. By entering into transactions, participants are contributing their best guess to the actual fair value of a given security. Neither party may have the exact right price, but the combined guesses of all participants becomes the best estimate of the fair value. In a perfectly informationally efficient market, all available information will be included in the prices of securities, but markets don’t have to be perfectly efficient to make picking stocks a loser’s game. The idea of picking stocks revolves around someone’s ability to determine that the current price of a security does not reflect its fair value. A person may decide that the current price of a stock is too low in which case it is a buy, or that it is too high in which case it is a sell. When the market corrects itself to reflect the fair value, the investor will profit. The problem with this, though, is that even if it is possible to accurately determine at a given point in time that a security is mispriced, the new information that is constantly being acted on by other market participants will render any prediction at some point in time useless. The ability of anyone to outperform the market will only be realized as randomly as the development of new information which, by definition, is random; we can’t predict the future. Even if markets are not perfectly efficient, intense competition gives them the ability to incorporate new information into prices. Under these conditions, picking stocks is foolish at best. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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