Efficient Market Hypothesis is the term used in the context of stock prices, according to this theory stock market is very efficient and that is the reason why the current market price of stocks reflects the true value of the stock and thus one cannot obtain abnormal returns through fundamental analysis, technical analysis or market timing and the only way to earn return is by taking the risk. While this theory sounds simple but many people argue against this theory and that is the reason why one should look at some of the advantages and disadvantages of the efficient market hypothesis –
Efficient Market Hypothesis Advantages
Save Money of Innocent Investors
The first and foremost advantage of the efficient market hypothesis is that it helps in saving money of innocent people who try to enter into the stock market thinking that they can earn huge money by following the advice of technical analyst or fundamental analyst as in the case of stock markets small retail investors come into the stock market at the end of bull markets and end up buying stocks at inflated levels only to sell them in huge losses. In simple words, the efficient market hypothesis makes it clear that the stock market should be viewed as a speculative game and not a place where one can earn a consistent abnormal return by buying undervalued stocks and selling overvalued stock.
Neutralizes Self Made Experts
Another benefit of this theory is that once you know that the stock market is efficient and reflects the true value of stocks that you will not get into the trap of buying blindly any stock on the basis of the recommendation of self-made experts who keep giving advice regarding stocks on various social media platforms as the majority of people end up burning their pocket by investing in the stocks on the basis of the recommendation of self-made experts.
Saves Time
Once you are aware that stock markets are efficient than you do not need to spend too much in analyzing the balance sheet, profit and loss accounts, and technical charts of stocks as according to this theory they are of no use and one cannot make an abnormal return by taking the decision on the basis of these tools. In simple words just like in speculation you place bets on your gut feeling in the same way according to this theory you should buy or sell stocks according to a gut feeling which requires no research and analysis.
Efficient Market Hypothesis Disadvantages
Markets are Irrational
The first and foremost disadvantage of the efficient market hypothesis is that while this theory argues that markets are efficient but history is filled with examples where stock markets become irrational due to panic and stocks were available at throwaway prices and people made a lot of money by buying stocks at throwaway prices. Hence the argument that market timing can do nothing fails due to the irrational nature of stock markets and an individual can make money by buying undervalued stocks during the market crash and selling overvalued stocks during market exuberance.
Fundamental and Technical Analysis Works
The argument that fundamental analysis and technical analysis are a waste of time is also not correct because just chances of accidents happening due to the bad driver are more as compared to a good driver in the same way while there can bad fundamental analyst or technical analyst but saying that fundamental and technical analysis is of no use is not the right thing to say as there are many people who have to earn consistent above normal return following fundamental analysis and technical analysis.
Stock Markets is not Gambling
The argument that stock markets is nothing but speculation is flawed as in the case of gambling one places bets on the basis of his or her gut feeling but when it comes to stock markets one takes risks but it is not only on the basis of gut feeling but other factors like the financial position of the company, market trend, technical trends, economic and stocks specific news and so on. In simple words risks taken in stock markets are calculated ones as opposed to gambling which is nothing but pure speculation.
As one can see from the above that efficient market hypothesis has pros as well as cons and that is the reason why anyone thinking that this theory is the holy grail of the stock market should think again as no theory can give a guaranteed return as far as stock markets are concerned.