Students will be able to:
- Explain the impact that efficient markets have on attempting to correctly time the stock market.
- Explain why stocks are treated as long-term investments.
In this economics lesson, students will read and discuss a joke about market efficiency.
Ask the students: What does EMH stand for? Pause for students to answer. Explain to students that EMH stands for Efficient Market Hypothesis and that they will watch a short Youtube video to explain this concept What Is the Efficient Market Hypothesis? (EMH). Play video. After the video, ask students “What was an example of the efficient market hypothesis given in the video?” Discuss the example of the space shuttle explosion and the impact on the stock market as shown in the video.
Explain to the students that you are going to read to them two stories. Distribute the Market Efficiency handout. Read the following article “Can Throwing Darts Beat Hedge Fund Managers’ Stock Picks?” by Wall Street Journal. You may need to purchase access if not a subscriber and use up free articles.
Check for understanding by having students play Kahoot! before moving on to the next topic.
Explain to the students that now they will complete an activity to learn more about stock prices and charts with a partner. Efficient markets theory states that one cannot look at charts and have any reliable insight as to what these stocks would do in the future. Examining charts to determine what a stock will do next is called “technical analysis.” There are many theories on how to examine charts for predicting stock returns. Go to Investopedia for further details on chart pattern.
With your partner, start with the “Introduction” link and take turns reading each step out loud until you get to “Conclusion”.
Have the students complete the Can You Be the Next Market Guru? interactive. Tell the students that now they are going to individually look at charts to predict the role of markets. Explain that for each stock graphed in the interactive activity below, decide what you would like to do.
As the students the following questions to check for understanding:
- Suppose you are watching the news one evening and the reporter states that Microsoft had reported earnings better than expected earlier that day. If the stock market is indeed efficient, would it be possible to buy Microsoft stock the next day and profit from this new information?
[No. Although the price of Microsoft stock most likely did rise after the positive announcement, it is too late for you to profit from this information. As soon as new information is reported, investors react immediately. Unless you were one of the first investors to hear the information, you will be too late. Think of it this way: if someone tells you there is a $20 bill lying in an aisle at Wal-Mart, this does not mean that you can go grab it an hour later. Someone else is likely to have already picked it up.]
- Suppose your next-door neighbor tells you that a new stock called XYZ issued shares on the New York Stock Exchange last week. He tells you most authoritatively that this stock is definitely going to skyrocket. Should you go out and buy this stock based on your neighbor’s advice?
[No. There is no reason to think your neighbor is any more adept at picking winning stocks than you are. Keep in mind that even the professionals who analyze corporations for a living often cannot choose undervalued stocks with any more accuracy than you might attain by throwing darts at a stock page.]
- Examining the information from question 2: Suppose you also know that your next-door neighbor is a high- ranking manager for XYZ and he tells you that–based on the latest sales figures for his company (which have not been released to financial news outlets yet)–buying this stock is a can’t lose proposition. Assuming markets are efficient, could you profit from this information?
[In this case you probably could profit from your neighbor’s advice since he has information the rest of the market does not have. However, it is illegal for him to trade on that information, and it is highly unethical and illegal for him to relay that information to you as well. This is what is referred to as insider trading. Company managers cannot buy or sell on any information that is deemed important before it is publicly announced. However, even with this rule, quite a bit of research does suggest that it’s a good idea to buy when insiders buy and sell when insiders sell. This is not to suggest that anybody is trading on insider information, but it does suggest that insiders have a better idea of the fair value of their company’s shares. Many sites detail the purchases and selling of shares by corporate insiders. See the following article on insider trading for more information.]
- What factors can you think of that might explain why U.S. stock markets are more efficient (i.e., that prices reflect all available information) than stock markets in less developed countries?
[The U.S. stock market is likely to be more efficient than most financial markets for the following reasons: a) More professional analysts following stocks. b) Better information about the companies that are analyzed. c) Better technology to analyze companies’ information, better software, computational power, etc. d) Faster dissemination of information via the Internet, television, etc. e) Better regulatory authorities to make sure the information being disseminated by corporations is accurate, Enron notwithstanding. f) Better markets in terms of being able to process orders, quote prices, etc.]
- If markets are indeed efficient, why do all these investment managers, financial analysts, mutual fund managers, etc., get paid for trying to find undervalued stocks?
[Keep in mind that somebody has to do the research to keep stock prices accurate–i.e., somebody is always looking for $20 bills lying around. Even if these managers do manage to find “$20 bills lying around,” after accounting for the time and effort it took to find them, they only earn enough to compensate them for their time and effort. Because all these analysts are constantly researching companies, we can be fairly confident, when buying or selling a stock, that we are getting the best price for it.]
Read the article “The Cocktail Party Fallacy” written by Eugene Fama who really focused attention on the concept of efficient markets back in 1970. Answer the following questions:
- Which companies have the highest expected returns?
[Poorly managed, distressed companies]
- What does the cost of capital mean?
[It means companies use stock to fund operating capital]
- Suppose you are a financial advisor. What advice would you give your clients after reading this article?
[Answers may vary, but could include buying stocks that are not the “glamorous” companies but companies that have the highest expected rate of return]