Review: Markets Are Right More Often Than You Think

This article let’s me get on my soapbox about one of my favorite topics: markets don’t need to be right to be efficient.

Oftentimes, people equate market efficiency with “right” or “perfect” market prices. That’s simply not true, and in fact, it doesn’t even mean anything. The folks who are advancing these arguments are either misinformed or simply putting up a strawman (generally to talk about how smart they are).

Let’s think for a minute about what would have to happen for the market to have “perfect” prices. At every second, all prices would have to be at their platonic values.

From here, it can go a couple of ways: either prices are always reacting to new information and moving to their new platonic values, or that new information was already incorporated in securities prices – the market is prescient and prices should largely just stay put (though going up would probably be ok), or somewhere in between.

Generally, people who suggest that prices have to be “right” to be efficient are somewhere in the middle. The markets need to be a little prescient so prices don’t move around very much – and we certainly shouldn’t have any big negative moves (again, the occasional big upward move would probably be ok).

But the world doesn’t actually work this way. Until we can predict the future, there’s no way to know what that next piece of news will be.

Financial markets operate by bringing thousands of people together to buy and sell securities. They’re all trying to make money. They don’t actually care what the “true” value of Apple is, or will be. They care about how they can make money from how the price of Apple will move in the next minute, hour, day, month, year, or decade.

These arguments about whether the market got it “right” or not usually come down to this: whoever is making the argument disagrees with something the market did. They thought Apple should have gone up, but it went down.

The market doesn’t care about your opinion. It’s just a bunch of people buying and selling stuff. It’s built on disagreements. It literally could not exist without these disagreements about the value of a security.

Unless you and I fundamentally disagree on how much Apple should be worth, there is no reason that you would want to buy my share of Apple. And it’s a self-correcting mechanism.

If enough people think Apple is underpriced, then they will come in and start buying up all of the “cheap” shares, and drive the price up to where they think it should be. This has zero bearing on whether a market is efficient or not.

The Efficient Markets Hypothesis doesn’t say anything about the markets getting anything right or wrong, it just says that you can’t predict where security prices are going next.

Stepping back from these arguments allows you to let the markets work for you. For more on how to do this, read A Minimalist's Guide to Understanding Financial Markets

 

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