Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Inefficient Market

What it is:

In economic terms, an inefficient market is a market in which securities prices are random and not influenced by past events. The idea is also referred to as weak form efficient-market hypothesis or the random walk theory (coined by Princeton economics professor Burton G. Malkiel in his 1973 book A Random Walk Down Wall Street).

How it works (Example):

The central idea behind an inefficient market is that the randomness of stock prices renders attempts to find price patterns or take advantage of new information futile. In particular, day-to-day stock prices are independent of each other, meaning that price "momentum" does not generally exist and past earnings growth does not predict future growth. Malkiel argues that people often believe events are correlated if the events come in "clusters and streaks," even though "streaks" occur in random data such as coin tosses.

In turn, technical analysis is undependable in an inefficient market, because stock prices already reflect all information. Fundamental analysis is also in these markets because analysts often collect bad or useless information and then poorly or incorrectly interpret that information when predicting stock values. Factors outside of a company or its industry may affect a stock price, rendering further the fundamental analysis irrelevant.

Why it Matters:

It is impossible to consistently outperform in the market when the market is inefficient, particularly in the short term, because it is impossible to predict stock prices. This may be controversial, but by far the most controversial aspect of the idea is that analysts and professional advisors add little or no value to portfolios, especially mutual fund managers (with the notable exception of those managing funds that take on greater risks), and that professionally managed portfolios do not consistently outperform randomly selected portfolios with equivalent risk characteristics. As Malkiel put it, "Investment advisory services, earnings predictions, and complicated chart patterns are useless... Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."