Financial Markets and Institutions (2-downloads)

announcements only when the information being announced is new and

unexpected.

If the news is expected, there will be no stock price response. This

is exactly what the evidence that we described earlier suggests will occur—that

stock prices reflect publicly available information.

Sometimes a stock price declines when good news is announced. Although this

seems somewhat peculiar, it is completely consistent with the workings of an effi-

cient market. Suppose that although the announced news is good, it is not as good

as expected. HFC’s earnings may have risen 15%, but if the market expected earn-

ings to rise by 20%, the new information is actually unfavorable, and the stock

price declines.

Efficient Markets Prescription for the Investor

What does the efficient market hypothesis recommend for investing in the stock mar-

ket? It tells us that hot tips, investment advisers’ published recommendations, and

technical analysis—all of which make use of publicly available information—cannot

help an investor outperform the market. Indeed, it indicates that anyone without bet-

ter information than other market participants cannot expect to beat the market.

So what is an investor to do?

The efficient market hypothesis leads to the conclusion that such an investor

(and almost all of us fit into this category) should not try to outguess the mar-

ket by constantly buying and selling securities. This process does nothing but boost

the income of brokers, who earn commissions on each trade.

1

Instead, the investor

should pursue a “buy and hold” strategy—purchase stocks and hold them for

long periods of time. This will lead to the same returns, on average, but the

investor’s net profits will be higher because fewer brokerage commissions will have

to be paid.

2

It is frequently a sensible strategy for a small investor, whose costs of manag-

ing a portfolio may be high relative to its size, to buy into a mutual fund rather than

individual stocks. Because the efficient market hypothesis indicates that no mutual

fund can consistently outperform the market, an investor should not buy into one

that has high management fees or that pays sales commissions to brokers but rather

should purchase a no-load (commission-free) mutual fund that has low manage-

ment fees.

As we have seen, the evidence indicates that it will not be easy to beat the pre-

scription suggested here, although some of the anomalies to the efficient market

hypothesis suggest that an extremely clever investor (which rules out most of us)

may be able to outperform a buy-and-hold strategy.

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