Is the “efficient markets” tale a myth? It can be pretty hard to feel comfortable that the markets are pricing stocks and exchange traded funds (ETFs) efficiently these days after witnessing wild price swings in either direction. How can you make sense of it?
As millions of smart buyers and sellers compete to maximize their wealth, they update stock prices with all the relevant information that’s available. That’s what it means to be an “efficient market,” explains Jason Zweig for The Wall Street Journal. Efficient markets mean that securities are the best estimate of “intrinsic value.”
Just because the market price is the best estimate on hand, however, doesn’t mean it’s right. Benjamin Graham, that great financial analyst, once said that the theory “could have great practical importance if it coincided with reality.”
The price of every stock is made up of two elements:
- “Investment value” measures the worth of all the cash a company will generate now and in the future.
- The “speculative element,” is driven by sentiment and emotion: hope, greed and thrill-seeking in bull markets; fear, regret and revulsion in bear markets.
Sound familiar? This is why the simple thought of trying to “beat” the market is not. Most actively managed mutual funds can’t outperform their benchmarks. If they can’t do it, the Average Joe shouldn’t assume that he can, either. In the short-term, the herd behavior of the pros makes it a Herculean feat to take a winning bet against the “speculative element” in a stock’s price. [Is there a way to cope with risk in the market this year?]
This is why it’s important to have a strategy, such as trend following. By watching market trends using the 200-day moving average, and by having a disciplined strategy that you stick to no matter what the herd is doing, you give yourself the opportunity to participate in any potential long-term uptrends and you strip away the emotional aspect of investing.
This is also another case for ETFs. By investing in a basket of shares that track a sector or a country, or the broad market, you can avoid the radical swings that a single stock can take and enjoy the benefits of lowered volatility. [Try setting a stop-loss, to keep losses minimal.]
For more stories about trend following, visit our trend following category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.