hand watch time

Time Picking Fails in an Efficient Market

hand watch time

The efficiency of communication has progressed as follows: horseback, slow boat, smoke signals, homing pigeons, flashing lights on navy ships, Morse code, telegraphs, telephones, radios, televisions, computer networks, and finally the Internet. With each step, information and news became cheaper, more accurate, and more rapidly disseminated.

The Efficient Market Hypothesis simply states that market prices accurately reflect all available information at all times. This leads to the conclusion that it is impossible to consistently beat the market averages. As Bachelier stated in 1900, the expected return of speculation is zero. The most recent studies by Richard Roll indicate that new information is reflected in market prices within five to sixty minutes. Within that sixty minutes there are hundreds or thousands of traders all competing to profit from the information. If you are in charge of one billion dollars, a 0.1% annual gain is worth one million dollars per year. Consequently, managers of those funds are applying considerable resources to squeeze out every little gain from new information. For this simple reason alone, there is an absence of opportunities for one trader to consistently profit from all other traders who have access to the same information at the same time! In short, all of us know more than any one of us and it is impossible for one person to consistently possess more knowledge than all the other traders combined.

DFA on Efficient Markets:

The efficient markets hypothesis (EMH) is an organizing principle for understanding how markets work and what investors should care about. Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In 1966, he developed the efficient markets hypothesis, which asserts that:

  • Securities prices reflect all available information and expectations.
  • Current prices are the best approximation of intrinsic value.
  • Price changes are due to unforeseen events.
  • Stock prices follow a random walk and are not predictable.
  • Although stocks may be mispriced at times, this condition is hard to recognize.

Viewing the markets as efficient has important implications. If current market prices offer the best available estimate of intrinsic value, stock mispricing should be regarded as a rare condition that cannot be systematically exploited through analysis and forecasting. Moreover, if new information is the main driver of prices, only unexpected events will trigger price changes. This may be one reason that stock prices seem to behave randomly over the short term.

The EMH implies that no investor will consistently outperform the stock market except by chance, and that all investors may be best served through passively structured portfolios. Rather than trying to out-research other market participants, a passive investor looks to asset class diversification to manage uncertainty and position for long-term growth in the capital markets.

Market efficiency argues that when securities become mispriced, market forces quickly push prices back toward fair value. This equilibrium does not depend on all investors having the same information or level of expertise. It only requires that many intelligent participants have information. No single investor will have all the information or know how to use it. In fact, no single investor can possibly have all the information, as it will be scattered among many participants who are all competing to maximize their potential profit as buyers and sellers. The market mechanism gathers the information, evaluates it, and builds it into prices.

It may be hard to conceive current stock prices as rational, especially when markets are extremely volatile. The EMH does not claim that markets are always rational or correctly factor information into prices. The only condition required is that a large number of market participants don't consistently exploit price differences to outperform the market average. Also, market efficiency does not rule out the possibility that some investors will earn above-normal returns. Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.

To summarize, market efficiency renders both stock picking and time picking useless.