Efficient Market Theory: A Contradiction of Terms

A detailed Summary of Efficient Market Theory: A Contradiction of Terms


Efficient Market Theory: A Contradiction of Terms

According to the Efficient Market Theory, it should be extremely difficult for an investor to develop a "system" that consistently selects stocks that exhibit higher than normal returns over a period of time. It should also not be possible for a company to "cook the books" to misrepresent the value of stocks and bonds. An analysis of current literature, however, indicates that companies can and do "beat the system" and manipulate information to make stocks appear to perform above average. An understanding of the underlying inefficient "human" factors in the market equation is necessary in order to account for the flaw in Efficient Market Theory.

Efficient Market Theory: A Contradiction of Terms

Efficient Market Theory (EMT) is based on the premise that, given the efficiency of information technology and market dynamics, the value of the normal investment stock at any given time accurately reflects the real value of that stock. The price for a stock reflects its actual underlying value, financial managers cannot time stock and bond s


The corollary of the theory must also then be true. An investor cannot be hurt by the market because the stock value of a poor or overvalued performer already reflects that fact in its price. The available information would indicate to investors that certain stocks are overvalued and subject to rapid decline. The availability of public information did finally force AOL into disclosing the ruse and changing its accounting practices, and coincidentally, lower the stock value to its true worth.

As a case in point, America Online (AOL) offers a classic example of how investors can be misled by a company that uses the market system against itself. AOL, up until early November of this year, used an accounting system that effectively "cooked their books" and provided misleading figures on the company's performance. Instead of accounting for its promotion expenses and costs as a regular expense, as normal companies do, AOL spread them over two years. This let AOL report annual profits based on revenue figures derived from denying actual expenses (as cited in Newsweek, November 11 edition).

This effectively ne

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