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<< Read More: The Biggest Myths In Investing, Part 7 – Fees Are A Small Price To Pay For Expert Advice
The Efficient Market Hypothesis says that all available information will get priced into assets efficiently. This means that more information will help us better arrive at efficient prices for financial assets. I’ve expressed my dislike of this idea in the past because, well, I just don’t find it that helpful. After all, it says nothing about whether these prices are “right” or “wrong”. It merely says that prices include all available information. In other news, water is wet. Alright, I’m being a little schmucky, but hear me out.
I would rephrase the EMH to include a temporal caveat – price efficiency is inversely proportional to time. In the long-term markets tend to be efficient, but in the short-term markets tend to be inefficient. Take a really simple instrument like a 10-year T-Bond paying 2%. This instrument will pay out its cash flows of 2% per year every year for 10 years. Of course, there’s a slight chance of credit risk and there’s always interest rate risk. So the bond’s price will fluctuate over its lifetime to reflect these risks. In the short-term, no matter how much information we have it will be very difficult to predict the interest rate risk. When you own the 10-year bond you are essentially buying an instrument in which the market will try to guess the 10-year interest rate risk. As a result, its price is always jumping around like no one knows what it’s worth. As I like to say, price is the equilibrium of liquidity where two willing parties agree to disagree.
