Is the Market Efficient?

Efficient market hypothesis claims that there is no way for an investor to make profits consistently in the future by making use of information available, and it is pure luck to beat the market in a row just as flipping a coin and getting heads in a row. If it were true, there would be no need for investment professionals to exist since people will be better off just investing in the market (i.e. index fund).

Thankfully, I disagree. Otherwise, I wouldn’t study finance at UIUC. First, when evaluating a business, the most common way, and I think the most appropriate way, is using Discounted Cash Flow (DCF) analysis. Simply speaking, the intrinsic value of a business is calculated by adding all the future cash flows during the lifetime of the firm and discounting them back to the present. If the market is efficient, then the prices of the firms in the market should already incorporate the future cash flows. I want to point out, however, that nobody actually knows about the future for certain. Since nobody knows, it is not proper to say the price in the market is efficient. The efficient market hypothesis, of course, says that it incorporates all the available information today, not the future cash flows but what makes the price of a stock go up (i.e. your investment performance) is not the today's earnings and news. It is the future earnings and news.

Second, if the market is efficient, we can’t have someone like Warren Buffett, Peter Lynch, George Soro, etc who have consistently beaten the market. You might argue that it is pure coincidence as in the coin-flipping game where about 10 people out of 10 millions will end up getting heads 20 times in a row by pure luck. As Warren Buffett once mentioned, however, if a group of the consistent market beaters come from the same place, you would be curious as to what is special about them. Most students taught by Ben Graham along with Warren Buffett have overall records to outperform the market over the past decades.

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