Last Updated Apr 5, 2010 12:27 PM EDT
At the core of the efficient market theory is that new information is disseminated to the public so rapidly and completely that prices instantly adjust to new data. If this is the case, you can consistently beat the market only with either the best of luck or with inside information (on which it's illegal to trade). The logical conclusion seems illogical to most investors: if information is valuable, it has no value. Thus, we have the information paradox.
There's a very simple and logical explanation of the paradox: The reason that valuable information has no value is that unless you're the only one to know it, the market has already incorporated it into prices. The only other way you can exploit information is to interpret it differently from the market. If you think it's critical to stay on top of the news regarding your investments, consider the following.
Gary Belsky and Thomas Gilovich relate the following story in their book Why Smart People Make Big Money Mistakes. Psychologist Paul Andreassen compared the performance of four groups of mock investors:
- One group was subjected to constant news reports about a company with a relatively stable stock.
- One group was given no news about the same stable company.
- A third group was given constant news reports about a company with a stock more subject to volatile swings.
- The fourth group was given no news about the same volatile company.
How can you avoid the mistake of confusing information with knowledge? Simply remember the following: Every time you hear or read financial news or a recommendation on a stock or asset class (technology stocks, small caps, emerging markets, etc.), ask yourself: "Am I the only one who knows this information?" If the answer is no, the market has already incorporated that information into prices -- and the information can't be exploited. Possession of an insight isn't sufficient. You can only benefit if other traders don't have the insight.