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Why Stock Prices Are Still Volatile in an Efficient Market

A reader writes in, asking:

“Last month Facebook’s price fell because the new European privacy law hurt their advertising revenue. I always see the ‘experts’ saying that we shouldn’t invest in individual stocks because an ‘efficient market’ makes it impossible to pick winners and losers. But the idea that every stock is perfectly priced all the time seems wrong on its face. I can tell you right now that if the U.S. passes a similar privacy law, Facebook’s share price will fall again.”

The idea of an efficient stock market isn’t that the stock market can predict the future. Nobody knows what is ultimately going to happen (either with Facebook or with any other company/industry/country).

That is, the market price for a stock doesn’t mean that this is where the price will stay; it’s simply the consensus best estimate, given the information that is currently available.

By way of analogy, imagine that I’m hosting a raffle, in which the winner gets $100. I’m going to sell exactly 100 tickets to the raffle. How much is each ticket worth?

Each ticket is worth $1, because each ticket has a 1% chance of winning $100. (That is, $100 prize x 1% probability of being the winning ticket = $1 value.)

Of course, the reality is that, of the 100 tickets, 99 of them will turn out to be completely worthless, and one lucky ticket will turn out to be worth $100. But we don’t know in advance which ticket will be the lucky one, so until the raffle actually happens, each ticket is worth $1. (In probability/finance jargon, we say that each ticket has an “expected value” of $1.)

The point of the efficient market concept isn’t that an efficient market would successfully predict which raffle ticket will be the winning ticket. Rather, the point is that an efficient market would successfully price each ticket at $1 prior to the raffle.

With regard to Facebook, there’s a possibility that new regulation will come along that impedes the company’s profitability, in which case the stock will be worth significantly less than it’s worth right now. Or, maybe no such event will occur, and the company’s stock price will rise back to what it was before all the hullaballoo.

But because we don’t yet know what’s going to happen, an “in the middle” price is the current consensus price, even though everybody knows it will ultimately turn out to be wrong (i.e., even though everybody knows the value of the company will ultimately turn out to be more or less than the current market value — just like everybody knows that none of the raffle tickets will ultimately be worth $1).

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