Efficient Market Theory

Abstract

According to the Efficient Market Theory, it should be extremely difficult for an investor to develop a "system" that consistently selects stocks that exhibit higher than normal returns over a period of time. It should also not be possible for a company to "cook the books" to misrepresent the value of stocks and bonds. An analysis of current literature, however, indicates that companies can and do "beat the system" and manipulate information to make stocks appear to perform above average. An understanding of the underlying inefficient "human" factors in the market equation is necessary in order to account for the flaw in Efficient Market Theory.

Efficient Market Theory: A Contradiction of Terms

Efficient Market Theory (EMT) is based on the premise that, given the efficiency of information technology and market dynamics, the value of the normal investment stock at any given time accurately reflects the real value of that stock. The price for a stock reflects its actual underlying value, financial managers cannot time stock and bond sales to take advantage of "insider" information, sales of stocks and bonds will not depress prices, and companies cannot "cook the books" to artificially manipulate stock and bond prices. However, information technology and market dynamics are based upon the workings of ordinary people and diverse organizations, neither of which are arguably efficient nor consistent. Therefore, we have the basic contradiction of EMT: How can a theory based on objective mechanical efficiency hold up when applied to subjective human inefficiency?

As a case in point, America Online (AOL) offers a classic example of how investors can be misled by a company that uses the market system against itself. AOL, up until early November of this year, used an accounting system that effectively "cooked their books" and provided misleading figures on the company’s performance. Instead of accounting for its promotion expenses and costs as a regular expense, as normal companies do, AOL spread them over two years. This let AOL report annual profits based on revenue figures derived from denying actual expenses (as cited in Newsweek, November 11 edition).

By deferring those costs, AOL over the years reported profits $385 million greater than they would otherwise have been. The company then used these non-existent profits to promote itself as a money-making opportunity for both stockholders and potential investors, artificially increasing its stock prices. This accounting practice is perfectly legal, but the information was kept private for over two years.