To prove the hypothesis lets go through a simple piece of logic. Suppose you discover a new technique that allows you to decipher patterns in the stock market, thus making Wall Street predictable. Let's say that you know that the stock market always starts rising when stock XYZ's price hits 15, and the market starts to fall when the price reaches 25. This constitutes a market imperfection, as you know the true value of securities before the market does. First of all, congratulations, you will soon become a very wealthy person! If you can tell when the market will go up and down, you can buy at the low point and sell at the precise high point. Well as your millions start to roll in, people will start to notice you. Human nature will cause others, who are seeking easy money, to copy your trading technique. Thus, as you start buying stocks so will everyone else, and conversely as you try to sell your stocks everyone will follow. However, not all of the trades will go through at once. The people at the end of the line will have to buy for higher prices and sell for lower. These people will learn from their mistake, and so will anticipate stock XYZ's price hitting the magic number. Thus, they will buy at 15.1 and sell at 24.9, thereby beating everyone to the punch and earning an extra bonus. Not to be outdone, the losers of the last round will now start buying at 15.2 and selling at 24.8. Obviously, the process will continue, and soon people will be both buying and selling at 20. Now the stock will not budge off 20, while the market as a whole will keep moving in whatever direction, now independent of the stock it was once linked to. The market is now random. In actuality, the market plays out this exercise hundreds of times a day, only faster. When a pertinent piece of information becomes public (a currency report, a company earnings release, a political development), the thousands of individuals in the marketplace, looking to serve themselves, will cause stock prices to adjust instantaneously to the changes in supply and demand. This prohibits the possibility of an individual reading about a story and acting on it before others can, thus earning excess profiting. In this scenario we have an efficient market, meaning that their is no excess economic profit, otherwise people would rush to the security offering excess profit, instantly driving the price up and wiping out the excess profit, just like in our example.

A phenomenon known as random walk characterizes efficient markets. Securities, over the short term, move randomly in accordance with the random introduction of news events. Do not confuse the meaning of random movement. Stocks react to news stories in a perfectly logical manner; it is just the randomness of news stories. However, one thing remains predictable; the long-term trend of security prices, which move upwards in accordance with economic growth in the country.

A brief review of the strategy outline reveals the value of indexing, the only strategy which does not rely on non-existant market imperfections. Instead, it keys in on long term growth, matching the reality of markets. Other strategies, in effect, trade themselves out of profit. By jumping into and out of the market you tend to miss rallies, which are longer and bigger (otherwise the stock market would contract in the long term), than declines. Also, the use of active management just turns over the portfolio, creating additional brokerage fees and taxable events that negatively impact returns.

Therefore indexing maximizes returns in efficient markets. The next question; are all markets efficient? Our example, proving the efficiency of markets, relied on the basic assumption that new public information becomes available to all market participants at the same time. In the example, everyone had access to the price of that magic stock allowing for instantaneous price adjusting. If, on the other hand, you could always get the price first, the scheme could be continued on indefinitely, and the market becomes inefficient. In the US the assumption of uniform and timely information release is valid. Individuals can download information from the Internet twenty-four hours a day for free. No one has an advantage. However, this assumption may not hold for all countries. If the assumption is invalid, other strategies like value investing may prove a better alternative. So lets look at how you can examine the efficiency of information dispersal.

First, investigate whether rules exist to regulate the uniform release of information in the market under consideration. In the US, the SEC regulates this. Also, determine how readily an individual investor can access information. Can you get news on a given security on the Internet? Another good measure is the liquidity of the market. Look at the overall daily volume of the market. Do most securities have a decent trading volume every day, or is most of the market volume concentrated in a few securities? Most markets, in developed nations, like the US, Japan, France, England, and Germany are efficient. The emerging nations, such as Latin America, Eastern Europe, and much of Asia, are generally less efficient, and as such active management in those markets can increase returns. Fund managers, who have the resources, can physically visit emerging countries and unearth good companies. The same information you take for granted in the US, earnings reports and so on, can be difficult to find in emerging markets.

This section concludes part II. Click here to return to the strategy homepage.