› Efficient market theory

Efficient market theory

Any trader strains his mind and nurtures, trying to squeeze the profit of the market. And suddenly an unpleasant news comes - efficient market theory. Supporters of this theory are mostly economist teachers, they say that prices reflect all of the accessible information about the market. Buyers and sellers actions depend on their total knowledge and the latest price reflects everything which is known about the current market conditions. Theorist of the effective market make a surprising conclusion out of this rather reasonable observation: nobody can win in the market. If the markets know everything, then playing with them is like trying to win against the chess world champion. It would be better not to waste time and money, and to buy a portfolio of shares which reflect the overall market (it is called indexing).

What about traders who make a hell lot of money? Their success is just a luck, according to the efficient market theory’s point of view. Any trader can scoop at any particular moment, but the market takes everything back very soon. What can you say about those traders who make money year-over-year? Warren Buffett, one of the greatest investors of the twentieth century says that to play in the market where people believe in efficiency is like playing poker with people who do not look in the cards.

We think that this theory contains one of the most reasonable views on the market. At the same time, we suggest that this theory is one of the most delirious. It points quite rightly to the fact that the market reflects the knowledge of its players. But the fatal miscalculation is that investors and traders, according to this theory, are smart people, seeking to maximize the profit and minimize the loss. This is an extremely idealized view of people’s nature.

It is easy to remain calm and sane on Sunday when the markets are closed. Traders analyse the charts with a reasonable approach, they decide when to buy or sell, they look for levels where they can take the profit or set the stop-order. But here Monday comes, the markets open, and carefully composed plans are getting crumpled in sweaty trader’s hands.

People make decisions in the markets partially by their head and partially with the emotions. They can buy or sell, even if that decision hurts them. A trader, who has rising shares, starts to be bragging and he misses sell-signals. A trader, beaten up by the market, becomes so fearful that he sells his shares on a minimal decline of the price, breaking his own trading rules. He cannot resign himself that he missed a profitable deal when his shares are getting above the level where he planned to take the profit, and that leads to a buy at an unreasonably high price. The surge is over and the price starts to slide down while the poor fellow looks with a hope initially and then with a horror that his shares are getting collapsed. At the end of the day, he sells with the loss at the real bottom as he can not stand any more. What rationale is in here? Maybe, the initial plan to buy those shares was smart enough but its implementation created a storm of emotions which drowned the trader.

Emotional traders do not think a lot about the long-term interests. They are not up to that - they whether puddle from adrenaline, or they are constrained by the fear and think just about how to get fingers out of the mousetrap. Prices reflect the deliberate actions by traders, but they also reflect the mass hysteria. The more active market is, the more emotions are around. People who think in a sober way are in the minority among the traders with sweaty hands, beating hearts and blurred consciousness.

Emotional traders
Source: StocksToTrade.com

Markets are more effective in trade corridors when people work mostly by the head. The effectiveness is getting decreased when prices accelerate and the emotional pressure is getting higher. It is tough to make money on small fluctuations of the price when your competitors are relatively calm. A cool-blooded enemy is more dangerous. It is easier to seize the money of traders who get excited during a fast-moving trend. Emotional behavior is more primitive and more forecastable. You need to stay calm in order to win in the exchange trading, taking money from excited dilettantes.

When a person is alone, he is keen on more rational actions. His steps are getting more impulsive in a crowd. His interest in any particular share, currency or future contract draws him in a mass trading on the same asset. The price is moving up and down and traders’ heads rise and descend with every price tick. Traders are getting hypnotized by the market like a snake is getting hypnotized by an Eastern fakir, rhythmically swinging by his fife. The faster prices change, the hotter emotions are. The emotional market is much less effective, and such a low effectiveness gives an opportunity for experienced traders to make money.

A serious trader makes money on fidelity to his own rules. The crowd is running for s rising share and throws it out with the price decline, yelling with the fear. The disciplined trader sticks to the plan during all that time. He can use a mechanical trading system or play by the situation, watching the market closely and making buy or sell decisions. In any case, he is guided by crisp principles, not emotions, and this is his advantage compared to the crowd. An experienced trader stretches money out of the hole in the ‘efficient market theory’, according to which, traders and investors are rationally thinking people. The majority of them are not suchlike, this feature is for winners only.

If you like this article, you might also be interested in this What is the price?

Read also

You have successfully registered

You can choose the needed type of account at any time!