Can You Rely on the Stock Market Long Term?

As market volatility increases and predicting share price fluctuations becomes ever more difficult, can you rely on the stock market being rational over the long term?

Cherry Reynard 27 January, 2016 | 9:28AM
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Are equity markets rational? The favoured argument among active fund managers is that they are irrational in the short-term, and rational over the longer-term. In the short-term, they are buffeted by economic noise, short-term and passive investors, and the machinations of central bankers, but over the long-term a company’s fundamental economic characteristics will emerge and be reflected in the price. But does this premise bear examination?

Impossible to Buy Undervalued Stocks?

The ‘efficient market hypothesis’ proposed by Professor Eugene Fama has come under increasing scrutiny in recent years. He argued that stocks always reflect all the available information and therefore always trade at their fair value, making it impossible for investors to buy ‘undervalued’ stocks. This has been challenged by academics including Justin Fox, who wrote the “Myth of the Rational Market”, Robert Shiller, who won a Nobel prize for predicting both the Internet crash and the housing bust and Lawrence Summers, now a senior official in the Obama administration. Their arguments differ, but they all agree that markets are – at best – rational over the longer term and certainly not over the short-term. 

It is a question worth asking in the current market environment because many commentators have suggested that the sell-off is irrational, based on weak analysis of the situation in China. If the sell-off is indeed irrational, and investors can expect a speedy reversion to the norm, then this would be a good time to buy equities.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BP PLC320.20 GBX0.77Rating
Glencore PLC330.50 GBX0.36Rating
Rolls-Royce Holdings PLC132.50 GBX4.38Rating
Tesco PLC257.50 GBX-0.79Rating

About Author

Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.

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