Why Traders Make Markets Inefficient

The Efficient-Market Hypothesis (EMH) is a popular theory within the world of finance. The idea behind EMH is that the stock market is "informationally efficient," meaning that a stock is always accurately valued at any given time based on the information that is publicly available about that stock.

According to EMH, there's no such thing as an "underpriced" stock, and the smartest, hardest-working investment banker at Goldman Sachs Group Inc GS has no trading advantage whatsoever over the most naive and uninformed home trader.

If EMH is true, every stock is accurately priced at all times.

What would EMH defenders say, however, about the fact that certain traders have track records of long-term outperformance? What would they say about traders who consistently buy stocks that subsequently rise in price (other than perhaps make snarky allegations of insider trading)?

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According to EMH, those stocks were never underpriced; those consistently successful traders simply consistently incorrectly overvalued those stocks. EMH subscribers would say that the concept of "buying low" is nothing more than underappreciating the risk involved in stocks.

Sourcing Market Inefficiency

Stock prices generally do reflect all publicly available information, but not always. Market inefficiency provides the windows of opportunity that successful traders pounce on to make winning trades. If stocks were never mispriced, there would be no possible way to consistently outperform the market.

One source of mispricing stems from the mechanism of the stock market: Information doesn't move share prices; buying and selling does.

While new information can instantly change the inherent value of a stock, it's up to the action of traders to actually move the share price. Traders, despite what many may think, are members of the human race. The level of inefficiency differs from one trader to the next, but it's always there.

What actually happens when a big piece of bad news about a stock comes out?

Blame The Traders

As soon as big news hits the presses, many of the most efficient traders will sell shares immediately, recognizing that the news adds an element of risk to the future of the company that is not reflected in the current share price.

Some traders might determine that bad news news will likely cause a temporary drop in share price, but decide they are willing to wait out a temporary drop because they believe in the long-term future of the company.

Certain traders might get spooked by the news and sell immediately, only to reconsider when they are more level-headed at a later date and decide to buy back in.

Lastly, a large number of traders are so busy with work, family or other responsibilities that they may not even read the news until the end of the week or the end of the month. These traders might sell their shares sporadically throughout the weeks following the news.

The point is that traders, who are solely responsible for changes in share price, are not perfectly efficient in their thoughts, emotions or actions. Even the most efficient and most wealthy traders often do not have the resources to move a large-cap stock to the "right" price instantaneously and all by themselves. If the traders that make up the market are not efficient, how can the overall market be efficient?

As conveniently simple as Efficient Market Hypothesis is, there is no reason any stock trader should subscribe to the theory. Here's why: If EMH is true, there's no point in trading stocks. Of course, this conclusion should be good news to all traders that believe they can outperform the market. Market inefficiency provides the opportunity to do so.

This story was originally published in October 2014.