Efficient Market Theory: A Contradiction Of Terms Essay

This essay has a total of 765 words and 4 pages.

Efficient Market Theory: A Contradiction Of Terms

Abstract
According to the Efficient Market Theory, it should be extremely difficult for an investor
to develop a "system" that consistently selects stocks that exhibit higher than normal
returns over a period of time. It should also not be possible for a company to "cook the
books" to misrepresent the value of stocks and bonds. An analysis of current literature,
however, indicates that companies can and do "beat the system" and manipulate information
to make stocks appear to perform above average. An understanding of the underlying
inefficient "human" factors in the market equation is necessary in order to account for
the flaw in Efficient Market Theory.


Efficient Market Theory: A Contradiction of Terms
Efficient Market Theory (EMT) is based on the premise that, given the efficiency of
information technology and market dynamics, the value of the normal investment stock at
any given time accurately reflects the real value of that stock. The price for a stock
reflects its actual underlying value, financial managers cannot time stock and bond sales
to take advantage of "insider" information, sales of stocks and bonds will not depress
prices, and companies cannot "cook the books" to artificially manipulate stock and bond
prices. However, information technology and market dynamics are based upon the workings of
ordinary people and diverse organizations, neither of which are arguably efficient nor
consistent. Therefore, we have the basic contradiction of EMT: How can a theory based on
objective mechanical efficiency hold up when applied to subjective human inefficiency?


As a case in point, America Online (AOL) offers a classic example of how investors can be
misled by a company that uses the market system against itself. AOL, up until early
November of this year, used an accounting system that effectively "cooked their books" and
provided misleading figures on the company's performance. Instead of accounting for its
promotion expenses and costs as a regular expense, as normal companies do, AOL spread them
over two years. This let AOL report annual profits based on revenue figures derived from
denying actual expenses (as cited in Newsweek, November 11 edition).


By deferring those costs, AOL over the years reported profits $385 million greater than
they would otherwise have been. The company then used these non-existent profits to
promote itself as a money-making opportunity for both stockholders and potential
investors, artificially increasing its stock prices. This accounting practice is perfectly
legal, but the information was kept private for over two years. The company has recently
announced that, effective immediately, promotion expenses will be charged to earnings as
the expenses are incurred, the way a normal company does. AOL will also take a one-time
special charge of $385 million for the "deferred" promotion costs.


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