What Is the Efficient Market Hypothesis?

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- [Narrator] What is
the efficient-market hypothesis?

The main idea behind the hypothesis

is that the prices of traded assets,
such as stocks,

already reflect
all publicly available information,

and thus if you're investing

based on
publicly available information,

you won't be able to systematically
outperform the market over time.

Think about it this way --

on average, buyers have
just as much information as sellers,

and vice versa.

So that means a stock is just as likely
to overperform the market

as it is to underperform.

Stock returns are hard to forecast
because old information

is already incorporated
in stock prices,

and new information is,
by definition, unexpected, or random.

Here's an example.

At 11:39 Eastern Standard Time
on January 28, 1986

the Space Shuttle Challenger
exploded in a great tragedy,

killing everyone on board.

Eight minutes later,

that news hit
the Dow Jones wire service.

Things were a lot slower back then
before instant messaging.

On that day, the stock prices
of all the major contractors

who had helped
to build the shuttle --

such as Morton Thiokol, Lockheed,

Martin Marietta,
and Rockwell International --

all fell immediately by 2 to 3%,
except for Morton Thiokol,

whose prices fell by over 11%.

As it turns out, the market
had correctly figured out

that Morton Thiokol was
the most likely cause of the disaster,

and within hours that information
was reflected in market prices.

A formal investigation
would not begin

for another six months,

during which time the failed O-rings
made by Morton Thiokol

were linked
to the cause of the disaster.

Now that was back in 1986.

Nowadays, new information
starts to change markets

not in hours or minutes,
but in seconds or milliseconds --

literally faster
than the blink of an eye --

making the efficient-market hypothesis
that much more efficient.

To learn more
about the stock market

and how it functions
as an economic institution,

click here.

Or, to test your knowledge
on the efficient-market hypothesis,

click here.

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