How does an efficient market affect your portfolio?

What You Should Know About Efficient Markets

Maybe you haven’t heard the exact term, but if you are a long-term investor there’s a pretty good chance that your financial portfolio was built in part on the tenets of the efficient market hypothesis (EMH).

While you probably don’t need to understand all of the heavy numbers and maxims behind EMH, it could be helpful to have a basic understanding of the hypothesis.

Giving Rise to Passive Investing

At its core, EMH suggests that it is nearly impossible to beat the average movement of asset prices (stocks and bonds, primarily) over the long term. Since all of the information that moves prices is available to everyone, no one can gain an edge. Therefore, the market behaves rationally with the same, shared information. 

The hypothesis has contributed to the rise of passive investing, which means you try to match the performance of a given market index by holding all or most of the securities in that index. By tracking a market index, investors could save the time, money and energy required to try beating the market averages. Passive investing helped fuel the exchange-traded fund industry because most ETFs attempt to duplicate the returns of indexes like the S&P 500.

“From an investor perspective, the efficient market hypothesis has led to an emphasis on low-fee index funds and an asset allocation strategy,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “Rather than trying to beat the market with individual stocks, you select baskets of stocks and bonds that reflect the entire market.”

Countering Market Efficiency

Detractors of EMH argue that it’s unlikely that all information that could move prices actually is known to everyone. In other words, some traders and investors can get an edge.

Active traders also point out that prices can move in certain patterns, despite the information that’s available to everyone. Some use elaborate charts to help them predict price movement. Others say humans are flawed beings who won’t always behave rationally – or in the same way – if given all available information.

“Traders are looking for an edge every day, sometimes every second of every day,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “I think it’s important to point out that every trade has a buyer and a seller. Are both sides acting rationally? We offer a lot of tools to help people get on the right side of their trades.”

Impact on Portfolios

Followers of EMH, and most wise investors, generally seek to create a portfolio that provides the best return at the lowest possible risk. That puts the emphasis on creating a portfolio of broad asset classes and determining how much money to put in each asset based on the amount of risk you want to take.

For example, you might put 50% in stocks and 50% in bonds. If you want to take more risk, you would consider putting more money in stocks and less in bonds. Of course, those are generalities. Some bonds are riskier than some stocks.

“For long-term investors, I wouldn’t obsess on whether the hypothesis is right, wrong or somewhere in the middle,” Correnti said. “An asset allocation strategy that emphasizes low-cost investments and a diversified portfolio is likely to work if it’s part of a plan that you stick to.”

Next Step: To understand more about asset allocation models, you can read 5 Models to Help Diversify Your Portfolio. Scottrade® clients can access the Portfolio Review Tool by logging in to their accounts.

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk, and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available by contacting Scottrade. Investors should read these carefully.

Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.

Investors should consider the investment objectives, charges, expense and unique risk profile of an exchange-traded fund (ETF) or mutual fund before investing. A prospectus contains this and other information about the fund and may be obtained online or by contacting Scottrade. The prospectus should be read carefully before investing.

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Investors should consider the investment objectives, charges, expense and unique risk profile of an exchange-traded fund (ETF) or mutual fund before investing. A prospectus contains this and other information about the fund and may be obtained online or by contacting Scottrade. The prospectus should be read carefully before investing.