THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 190

158 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 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 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