In principle the market functions as a discounting mechanism by pricing in all future information into the current price for securities of various asset classes. The hypothesis suggests this discounting mechanism is fully efficient in terms of price discovery.
There are 3 assumptions of the Efficient Market Hypothesis:
1) Equal access of information to all participants
2) Rational behavior of market Participants
3) Zero transaction costs
While it is hard to disagree with market participants having equal access to information, and zero transaction costs (thanks to pay for order flow) at most brokers, our greatest challenge to the Efficient Market Hypothesis being fully efficient in terms of price discovery clashes with assumption #2, the rational behavior of market participants, which suggests market participants act fully rationally at all times. Perversely, we understand the market price of securities in the short term is largely based on the pervasive sentiment ruling markets and the popularity of the issue, and to a much smaller degree on the logical reasoning and rational behavior of market participants.
Market inefficiencies can be characterized as a disconnect between price and value, which are likely the result of the irrational behavior of market participants.
During periods of low market uncertainty and stability, investors act with a greater degree of rational behavior. But it is during periods of macroeconomic crisis and distress, where markets can be characterized by extreme uncertainty, when market participants are devoid of logical reasoning and rational decision making, where decisions are based on emotion and overall negative market sentiment. Margin calls are an example of an institutional investor selling securities in distress, not based on the underlying value, but liquidating the securities only because of margin requirements set by the broker. The lack of rational behavior by market participants during these periods of calamity, helps foster the creation of opportune market inefficiencies to be exploited by disciplined investors.
If you are a high net worth individual or institutional investor with questions on how to identify market inefficiencies for securities of various asset classes, contact us for more information.