Efficient Market Hypothesis and Its Implications

This hypothesis suggests that incorrect pricing in the market is a transitory phenomenon. Stock prices fluctuate due to the emergence of new information.

An important consequence of the efficient market hypothesis is that it is impossible for any investor to consistently beat a market benchmark over a long period of time. Since every bit of information is quickly absorbed by this efficient stock price discovery machine, not even smart, diligent investors can have an edge.

Now, not many people would deny the remarkable foreknowledge that the market displays from time to time. Take the example of the behavior of the Indian markets in early 2020. After plunging nearly 30% in February and March on Covid-19 fears, the benchmark index Nifty 50 slipped to close to 8,100 on 3 April 2020. Interestingly, India’s daily tally of new cases for Covid-19 did not reach 500 on that day. Similarly, the daily Covid death figures did not even reach double digits. At that point, the Nifty 50 rebounded and rose in an almost linear fashion over the next 11 months, respite only after crossing the 15,100 mark in February 2021.

All this time, India was engulfed in the first wave of COVID-19. Despite the nationwide lockdown, the daily new cases and daily death toll rose sharply and reached 96,000 and 1,200 respectively in September 2020. In a way, the market foresight was that once the dust settled, the economy would turn around and corporate profits would return to normalcy. There have been many such examples in the past—both for markets and sectors, as well as for stocks.

However, there are some flaws in the shield of the efficient market hypothesis.

First, over the long term, there are a significant number of investors who have given portfolio returns above their benchmark returns, in a way that has debunked the theory.

Second, as with the release of any relevant information, the stock often moves the wrong way. For example, if a cement company announces a new project, the stock may soar when the news tape hits. Clearly, the market here is taking this project as a price increase for the stock. However, possible apprehensions regarding deterioration in the demand-supply dynamics of the industry with this project could lead to a fall in the stock on the next day. Thus, it is not just about correctly interpreting new information. Getting a fair value of a stock depends more on inferences about the future based on our understanding of the incremental data. It is this ability to prepare future results ahead of others that gives some investors an edge.

Third, there are times when a stock or market benchmark makes a big move without any new data points. Finally, if market pricing is efficient in stocks, dramatic changes where market indices move more than 5-7% in a day (for example on October 19, 1987, the Dow Jones index of the United States fell 22% ) should not be. ,

Investors who invest directly in stocks, knowingly or unintentionally, believe the markets are inefficient—at least partially. As above, there is ample evidence that this belief is correct. Furthermore, that markets are only partially efficient means that at least some can generate returns above the market. However, to get such returns, one must have a proper understanding of the way the market works. On the other hand, a vast majority of investors underperform the benchmark. The market being somewhat efficient makes it extremely difficult to beat the benchmark. Therefore, investors who are unable to devote enough time and do not have some basic understanding of accounting and finance, may be able to increase their chances of wealth creation by investing in passive funds or good active fund management vehicles instead of investing directly in stocks. can. ,

Vipul Prasad is the founder and CEO of Magadh Capital LLP

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