1. Home
  2. >
  3. stock strategies
  4. Understanding Efficient Market Theory

    Efficient Market Theory is a hypothesis that says that the price of a stock is determined by the stock market. This is because of stock market efficiency, that ensures that stock prices reflect and incorporate every related bit of information.

    The essence of Efficient Market Theory is to guarantee that investors do not buy undervalued stocks or sell overpriced stocks. Hence, stocks are traded at their real value, and nobody can outperform the entire market through expert market timing or stock selection.

    Investors and traders that believe in the theory are of the opinion that the market is capable of determining the real price of stocks. If a stock price is inflated, the price will fall to its actual value. If the stock price is undervalued, the price will increase to its real value. With this belief, the efficient-market specialists invest solely because of price and disregard other factors.

    Is the stock market efficient?

    Many practitioners believe that Efficient Market Theory is not true, although it is interesting. In the real-life situation, the market can overprice or undervalue investments. In fact, the stock market can fluctuate so wildly that prices cannot reflect the real value of some stocks.

    Reasons Why the Efficient Market Theory Often Fails

    There are some reasons why the Efficient Market Theory cannot work all the time.

    1. The bulk of buy and sell decisions are often made by people who are influenced by emotion. Most investors buy stocks out of excitement when the stock market is buoyant and sell stocks when the market is declining due to fear. Most of their decisions are subject to personal beliefs, prejudice, and intuitions.

    2. All investors or players on the floor of the stock market cannot have access to all information regarding every stock or security they deal in. Certain external factors can significantly influence the prices of stocks and securities.

    3. Management of businesses do not always reveal the true data or information about the performance of their companies. Contrary to the laws mandating such disclosures. They often falsify or distort the information that they cannot hide.

    The real value or price of a stock may be very difficult to determine due to the factors explained above and many more factors. The Efficient Market Theory can be considered inefficient when determining or forecasting the real value of stock.