When investors put money into the stock market, they not only want to make a profitable return, but they also want to outperform, or beat, the market. The efficient market theory takes the stand that outperforming the market is not possible. This theory follows the belief that any time a trader buys or sells a stock that it is a “game” of chance, rather than any requiring any skill. If the market is efficient, this theory follows, it means that all of the information about the stock is revealed, leaving no possibility to buy stocks at a bargain price. In an efficient market, prices become random, rather than predictable, so that an investment pattern cannot be evident.

Challenges to the Theory

Efficient market theory has a number of dissenters, largely because it has been proven that it is possible to outperform the market. Investors such as Warren Buffet have made millions by investing in undervalued stocks. Many people are making plenty of money because they are skilled at predicting stock market changes. This ability smacks at the idea that the market is totally random.

However, under efficient market theory, the market does not always need to work at fair market value all the time. There is a mean value. Stocks will move above and below that mean value, but eventually will return. Efficient market theorists also say that outperforming the market does not rely on skill but on luck. In gambling, the higher the risk (ie, the more you play), the greater the return when you win. Stocks, in this theory, follow that same idea.

Degrees of Efficiency

For the market to become efficient, investors must believe it is currently inefficient and beatable. Inefficiency, according to efficiency market theory, is a temporary state. Buyers need to take advantage of the inefficient market, where prices are low and can later be sold high, before it becomes efficient again.

There are three degrees of efficiency. Strong efficiency states that all information about a stock is accounted for in its price. Semi-strong efficiency states that all public information is accounted for in the share price. Weak efficiency states that all past information is reflected in the current price.