When it comes to investing, many economists believe that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio of stocks that would do just as well as Wall Street professionals. The idea that picking good stocks is just a matter of luck comes from a fundamental theory in financial economics known as the Efficient Market Hypothesis (EMH).
Introduced by Eugene Fama in the 1960s, the essence of EMH is that at any moment, the price of a stock fully reflects all available and relevant information. It is believed that when information becomes public, the news spreads rapidly and gets assimilated into the stock price without delay.
A key implication is that the price of a stock should follow a random walk; that is, changes in the price are impossible to predict. Since information gets immediately incorporated in the stock price, price changes should occur only when new information comes to light. And because news, by its very nature, is unpredictable, it follows that price changes are likewise unpredictable.
If you subscribe to this theory, it wouldn’t be very useful to spend hours researching balance sheets and income statements to determine which stocks are good buys. After all, if prices already reflect all available information, then no company’s stock is either undervalued or overvalued.
Of course, as is often the case in Economics, such theories don’t always work the same way in the real world as they do on the blackboard. For example, Warren Buffett has demonstrated an uncanny ability to consistently pick stocks that perform far from randomly; and, stock price levels during the dot-com bubble of the late 1990s suggest that prices aren’t always perfect.
Investing as art or science? My money’s with the blindfolded monkey.