The efficient market hypothesis states that the price of a publicly traded stock or bond in a large, heavily traded market like the New York Stock Exchange, is a fair market price that accounts for all publicly available data about the company. What that means in practice is that any time you buy or sell a stock or bond at the market price, you should feel confident that you’re getting the best available deal for that transaction. To unpack why, let’s look at what would happen if this weren’t true.
If all publicly available information weren’t reflected in a stock’s or bond’s price, that would create arbitrage opportunities for resourceful investors. Let’s pretend that a company issues a press release about a new customer. That’s clearly a good thing for the company, and we would expect the company’s value to increase because a new customer should imply more revenue and more profit. If the price of the stock didn’t rise to account for that additional value, there would be an opportunity for investors to acquire the stock at a value lower than what a reasonable investor should want to pay. For the first investors to find this press release, they realize that they can start buying up shares in the stock at a particularly attractive price. Quickly, they snap up shares of the stock at that attractive price until no one is available on the other side willing to sell their shares at less than the fair price. At this point the investor stops buying, and the stock price reaches an equilibrium at the price that accounts for the press release. The buying activity increases the price until the effects of the press release are fully priced in.
Because access to the type of public information that would impact the stock price is universally available, sellers should also quickly adjust the price at which they sell. Between buyers searching for arbitrage opportunities and sellers making sure they’re not being taken advantage of, the current price of a security should reflect any public information.
An even stronger version of the efficient market hypothesis says that all private information is included in the current price as well. This should be the case because insiders can buy and sell securities as well.
Detractors of this theory point to bubbles, stock market crashes, and star investors as counterarguments that stocks do not trade at or near their fair market values. Over the long run though, bubbles deflate, crashes correct, and star investors fail to replicate above market returns, especially after fees are taken into context. Together, the evidence should make you confident that when you’re buying or selling at the market price, you’re getting a fair deal.