In order for markets to properly set prices and values, two conditions are necessary:
willing buyers and sellers, and those same participants' possessing perfect knowledge.
Should one side possess more information than the other, then that side has a tremendous advantage.
Therefore, the holder of the information can utilize this additional knowledge to extract "undeserved profits".
Since markets are the very heart and soul of the capitalistic system,
the system's invisible hand not only sets prices, but determines how goods and services are distributed,
and encourages further growth of the system with benefits for all.
For markets to work at all, there must be a general feeling that they are fair.
An issue that is the subject of intense debate among academics and financial professionals
is the Efficient Market Hypothesis.
This hypothesis states that at any given time,
security prices fully reflect all available information.
An "efficient" market is one where there are large numbers
of rational, profit-maximizers actively competing with each other
and trying to predict future market values of individual securities.
It is a market where current information is freely available to all.
In an efficient market, competition leads to a situation where,
prices of securities reflect information based both on events that have already occurred
and on events which the market expects to take place.
In other words, in an efficient market at any point in time
the actual price of a security will be a good estimate of its intrinsic value.
The implications of the efficient market hypothesis are truly profound.
Most individuals that buy and sell securities,
do so under the assumption that the securities they are buying are worth
more than the price that they are paying,
while securities that they are selling are worth less than the selling price.
But if markets are efficient and current prices fully reflect all information,
then buying and selling securities in an attempt to outperform the market
will effectively be a game of chance rather than skill!
But, on the other hand, let's suppose for the sake of argument that investors, as a whole,
are lemmings and markets systematically misprice stocks.
Such a market would surely be an easy game for a smart investor with real analytical skills!
But, there's more than just one smart guy out there!
There are thousands of expert analysts looking for over or under-valued securities.
The opportunities to generate excess profits are diminished when these expert investors
trade away disparities between price and value.
In other words a relative few people with little bits of true information determine prices.
The problem is that the smarter and more enthusiastic those few are,
the more they ruin things for each other,
and the market gets more and more efficient!
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