THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 190

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PA R T I I

Efficient
Market
Prescription
for the Investor

APP LI CAT IO N

Financial Markets

What does the efficient market hypothesis recommend for investing in the stock
market? It tells us that hot tips, investment advisers published recommendations,
and technical analysis all of which make use of publicly available information
cannot help an investor outperform the market. Indeed, it indicates that anyone
without better information than other market participants cannot expect to beat
the market. So what is an investor to do?
The efficient market hypothesis leads to the conclusion that such an investor
(and almost all of us fit into this category) should not try to outguess the market by
constantly buying and selling securities. This process does nothing but boost the
income of brokers, who earn commissions on each trade.6 Instead, the investor
should pursue a buy-and-hold strategy purchase stocks and hold them for long
periods of time. This will lead to the same returns, on average, but the investor s net
profits will be higher, because fewer brokerage commissions will have to be paid.
It is frequently a sensible strategy for a small investor, whose costs of managing
a portfolio may be high relative to its size, to buy into a mutual fund rather than individual stocks. Because the efficient market hypothesis indicates that no mutual fund
can consistently outperform the market, an investor should not buy into one that has
high management fees or that pays sales commissions to brokers, but rather should
purchase a no-load (commission-free) mutual fund that has low management fees.

As we have seen, the evidence indicates that it will not be easy to beat the prescription suggested here, although some of the anomalies to the efficient market
hypothesis suggest that an extremely clever investor (which rules out most of us)
may be able to outperform a buy-and-hold strategy.

What Do the Black Monday Crash of 1987 and the Tech
Crash of 2000 Tell Us About Rational Expectations and
Efficient Markets?
On October 19, 1987, dubbed Black Monday, the Dow Jones Industrial Average
declined more than 20%, the largest one-day decline in U.S. history. The collapse
of the high-tech companies share prices from their peaks in March 2000 caused
the heavily tech-laden NASDAQ index to fall from around 5000 in March 2000 to
around 1500 in 2001 and 2002, for a decline of well over 60%. These two crashes
have caused many economists to question the validity of efficient market theory
and rational expectations. They do not believe that a rational marketplace could
have produced such a massive swing in share prices. To what degree should these
stock market crashes make us doubt the validity of rational expectations and the
efficient market hypothesis?
Nothing in rational expectations theory rules out large changes in stock prices.
A large change in stock prices can result from new information that produces a

6

The investor may also have to pay Canada Revenue Agency (CRA) capital gains taxes on any profits
that are realized when a security is sold an additional reason why continual buying and selling does
not make sense.