---
title: "What Does the Efficient Market Hypothesis Mean for Value Investors?"
description: "The efficient market hypothesis suggests that stock prices always reflect the underlying value of the business. Can value investors still find bargains in the market?"
canonical_url: https://trendshare.org/how-to-invest/what-does-the-efficient-market-hypothesis-mean-for-value-investors
markdown_url: https://trendshare.org/ai/what-does-the-efficient-market-hypothesis-mean-for-value-investors.md
published: 2014-10-12
last_updated: 2020-12-31
content_license: https://trendshare.org/about/disclaimer
---
# What Does the Efficient Market Hypothesis Mean for Value Investors?

Source: https://trendshare.org/how-to-invest/what-does-the-efficient-market-hypothesis-mean-for-value-investors
Updated: 2020-12-31
Everyone seems to have an explanation for [daily fluctuations in the stock market](https://trendshare.org/how-to-invest/what-happened-in-the-stock-market-today). Somehow, not everyone makes lots of money exploiting these
fluctuations. In the long term, the most coherent belief in the market is that
the price of a stock will reflect the business value of the company. In the
short term, anything goes.

Right?

## The Efficient Market Hypothesis

If you dig into the theory of investing, you'll find a lot of unique beliefs.

For example, the efficient market hypothesis suggests that the market as a
whole tends to find the best price for stocks all the time. At any point in
time, the price of any stock reflects all of the information available about
the stock and its business.

At first glance, this makes intuitive sense. The market *is* a
weighing machine. At any point in time, the price of a stock represents an
agreement between buyers and sellers. The most recent successful trade
represents a price where someone willing to sell a stock found someone willing
to buy that stock.

For a huge stock such as [Ford](/stocks/F/view), [Coca-Cola](/stocks/KO/view), or [Google](/stocks/GOOG/view), millions of shares trade hands every day.
Thousands (hundreds of thousands?) of buyers and sellers make trades every day.
For everyone who's bullish about the stock and wants to buy, there's someone
else bearish who wants to sell. You can see those trades take place and the
price fluctuate. Does the price really reflect *all* of the knowledge
about the stock?

The theory is interesting. How does it work in practice?

## Assumptions of the Efficient Market Hypothesis

If you take the EMH to its conclusions, you're unlikely to find [undervalued or overvalued stocks](https://trendshare.org/how-to-invest/what-is-intrinsic-value) because the
current price of any stock should be pretty fair.

One flaw in the efficient market hypothesis is that it assumes that the most
recent transaction of the stock reflects all of the information available about
the company. For a sale to happen, a buyer and a seller must actually complete
a transaction. They're doing so based on market information.

Think about it this way. If one person believes that Coca-Cola is about to
quadruple in price and wants to buy a billion shares for $0.01 apiece, what are
the chances of finding enough sellers to fill that trade at that price?

Is an offer to buy at $0.01 a legitimate piece of information about a stock?
Maybe it's not a *realistic* view or a realistic offer price, but it's
information.

Think this through. One person believes something outrageous. If that person
found sellers, would those transactions depress the value of the stock? Would
other people jump on that trend? (What if people had automatic trading rules to
sell their shares if KO went below a price threshold? What if several thousand
of those rules all flooded the market with offers to sell at a low price? What
does *that* represent about the company?)

Contrarily, what if I believe that my shares of KO are worth $100 apiece and
have a standing offer to sell them at that price? That may not reflect majority
opinion about the market, yet what has the efficient market decided when I
successfully complete a trade at that price?

Those are surface criticisms, however. A bigger problem of the EMH is that
it fails to account for [how easy it is to buy or sell shares](https://trendshare.org/how-to-invest/what-is-liquidity). Without enough buyers or sellers, how can any price represent
an equilibrium which accurately reflects investor sentiment? If only 3000
shares of [Jewett-Cameron](/stocks/JCTCF/view) trade hands every
day, is the sample size enough to represent consensus? Even if markets and
investors agree on the value of a stock agree, will a transaction actually take
place?

One of the worst assumptions of the efficient market hypothesis is how it
overvalues market price in general. What does *market price* mean? The
market price of a stock is that price, at a fixed point in time, where a buyer
and seller agree. That's it. What does that tell you?

## The Efficient Market Criticism of Value Investing

Proponents of the efficient market hypothesis have similar criticisms of
value investing. The most direct argument is that the market pricing model
offers few chances to find inefficiencies. In other words, you're not going to
see a stock underpriced long enough to jump on a good [value investing](https://trendshare.org/how-to-invest/what-is-value-investing) opportunity because the
market will quickly correct itself. Similarly, you won't find overpriced
stocks, because they'll be sold at a profit.

Do these arguments hold up? The former is circular ("efficiency means that
there are no inefficiencies") and the latter requires strict short-term
thinking ("I've made a profit on this stock, therefore there's no reason to
keep it").

Economics presumes the existence of a perfectly rational actor, but who is
perfectly rational in the ways that economists prefer?

If you're thinking "That's not the biggest problem with that argument,"
you're right! Perhaps it's not obviously rational to hold on to a stock that's
made a sufficient profit, but to make that assertion, you have to understand
ideas such as *rational* and *sufficient profit*.

Can any single analysis of the price of a stock account for investors as
diverse as the pension fund of an American state, a day trader, an elderly
retiree, and a 22 year old who's directed all of the contributions of her
401(k) into a [S&P 500 index fund](https://trendshare.org/how-to-invest/buy-the-s&p-index-fund)? Can
the irrationalities of one position counter fully the irrationalities of other
positions?

If I'm holding KO because I bought it at $6 per share and want to sell it at
$60 per share, what does that say about the underlying value of the stock? If
90% of investors are waiting for a best-case financial forecast scenario that
never comes true, what then?

## Intrinsic Value Versus Efficient Markets

Global financial insecurity may mean that fewer people buy sugary drinks (or
automobiles or gasoline or yachts) than if the global economy were flying high.

What does that mean in 2021? What did that mean in 2011?

Can you really condense that belief into a single price all day, every day?
Can that price *really* be correct? After all, not everyone with a stake
in the price of a stock makes an visible economic decision about that stock
every day. Some people [buy and hold](https://trendshare.org/how-to-invest/buy-and-hold) for years, quite
happily.

Meanwhile, the intrinsic value of a stock—the underlying business, its
assets, its debt, its ability to make revenue on invested
capital—continues *despite* investor sentiment. Of course,
investor sentiment may affect the business's ability to take on short or long
term debt, to approve plans which require shareholder votes, and to make other
management decisions—but these are discrete events, not continual votes
in a second-by-second popularity contest.

## How Efficient is the Stock Market?

Does that mean the stock market is inherently chaotic and inefficient? No.
Over time, successful businesses thrive. Unsuccessful or unscrupulous companies
go out of business. A well-managed business may have lean years and great
years, but [it'll continue making money for its investors](https://trendshare.org/how-to-invest/earnings-matter-most). Similarly, [a failing business may descend into penny stock status before going bankrupt](https://trendshare.org/how-to-invest/risks-of-penny-stock-trading).

Unsuccessful businesses don't last.

There will be inefficiencies in the market. There's incomplete information
about stocks. There are fears. There are structural reasons why large players
in the market (pension funds, hedge funds, institutional investors regulated by
the SEC) can only take limited positions for limited times. More than that,
there's asymmetry all over.

I may believe that Berkshire-Hathaway is the best investment position I
could take but I might not be able to afford $200k per share right now—or
no one might be willing to sell at that price.

## Value Investors Find Market Inefficiencies

If the market is relentlessly and maddeningly and unpredictably inefficient,
you can still make money investing. Step one is to identify inefficiencies.

The second step is determining your taste for profit. Are you a buy and hold
investor? Are you willing to [be more active and trade a few times a year](https://trendshare.org/how-to-invest/what-is-active-investing), when you've made your target amount of
profit?

There's no [secret formula to pick profitable stocks](https://trendshare.org/how-to-invest/is-there-a-secret-formula-to-pick-good-stocks), but if you stick with intrinsic value,
pay attention to earnings, and look at how well companies turn investor money
into accountable revenue, you may be surprised at how many opportunities the
so-called efficient market leaves available.