Market Efficiency

Market efficiency-Making money in stock market

Market efficiency is refer to which stock prices reflect all available, relevant information, it does not require that the market price be equal to true value at every point in time. The price can be greater than or less than the true value of the stock reflect.

The basic idea of the underlying market efficiency is that the competition will drive all information into the price quickly. All it requires is that errors in the market price be unbiased. This idea got its start at least in part due to Ball and Brown’s 1968 paper looking at earnings announcements. The authors found that the market had forecasted 80% of the news BEFORE the announcement and the 3 and 6-month returns AFTER the announcement was approximately zero.

market efficiency

How Efficient is the stock market

Few people consistently making money betting on horse races. In finance terms, the horse racing market is efficient. But is the stock market efficient? Some people argue that stock market is efficient and that you should not spend time trying to beat the market average. On the other hand, including Buffett, argue that the market is not efficient. Instead of thinking about the market efficiency, you should ask, “Can i make money in the stock market?” Making money in this case means generate above average returns. My answer to all this is “Yes, of course you can!”

As a starting point, consider these two questions, whether you should try to beat the market and help you start thinking about making money in the stock market:

1) Do most professional money managers generate above average returns in stock market?

2) Do most individual investors generate above average returns in the stock markets?


The answer is “No” for both questions above. Most of the time, the professional money managers can’t beat the S&P 500 index. Among those who can, few do it consistently. “If most money managers cannot beat the S&P 500 index, how can i?” Since most of the money managers do not beat the S&P 500 index, it should be clear that you should not listen to most money managers. What does it imply about reading the Wall Street Journal and watching CNBC? You should read newspaper and TV for facts, analysis and not opinions.

Even if the market were efficient, there is no harm in buying individual stocks using your own knowledge. In efficient market, you will not lose money even if you want to. Consider a game of tossing coin, you randomly call heads or tails. In this game, you will win fair and lose the other half regardless what you call most of the time. In stock market, on average, you will not lose money even if you want to. You will lose cost of trading in terms of brokerage fee, but as long as you do not trade often, you will do as well, or better than, most money managers.

Overall, the stock market can help you make money if you are willing to put in time and effort to develop the winning mind set to learn and play the game well. Since most of the people do not put effort, most of them do not beat the market averages. For these people, the market are efficient. For those who willing to master the game, even a small corners of a single industry, it should be possible to beat the market averages if willing to do some stock analysis.

 

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