Market Efficiency - Explained
What is Market Efficiency?
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Table of ContentsWhat is Market Efficiency?How Does Market Efficiency Work?The Origin of Market EfficiencyHow is Market Efficiency Used?Forms of Market EfficiencyHow Market Become EfficientArguments Against Market Efficiency
What is Market Efficiency?
Market efficiency is a metric used to measure how far market prices incorporate all the suitable, available information. In case the markets happen to be efficient, then it means that all the information is already integrated into prices and it, therefore, provides opportunities for those buying and selling securities to make profits. The element of profit-making is what makes investment managers have an interest in market efficiency.
How Does Market Efficiency Work?
Market efficiency is a financial tool used to measure the markets ability to incorporate information which in turn provides opportunities for buyers and sellers. This process effects a transaction without necessarily having to increase transaction costs. Basically, the market is assumed to be large and liquid. For this reason, it is essential that investors have access to cost information. Market efficiency means that the transaction costs should be low-priced compared to the expected strategy profits from investment. However, it is not possible to continuously do well in the market, especially where the prices of stock in the market are difficult to predict, within a short period of time.
The Origin of Market Efficiency
Market efficiency can be traced back to 1970 where an economist by the name Eugene Fama developed a theory known as Efficient Market Hypothesis (EMH). The theory stated that:
- It is impossible for a person investing to outperform the market
- There should be no market anomalies as they will be arbitraged away immediately.
Note that there are investors who are in agreement with this theory, usually purchase index funds which track total market performance as well as passive portfolio managements proponents.
How is Market Efficiency Used?
Investors, who value this theory, believe that at some point, stocks can be priced below the price they are worth. Those who manage to do a successful valuation of value stocks make great profits by buying stocks when their price is below and then sell them at higher prices once the price or the stock in the market is much above its basic value. However, there are those investors who are not certain about the existence of an efficient market as well as active traders. Such investors assert that as long as there are no opportunities for one to earn profits that outdo the market, there is no incentive for becoming a dynamic trader. Also, they believe that fee charges by the active managers are an indication that the transaction costs in the efficient market are low.
Forms of Market Efficiency
Market efficiency exists in three forms. They are as explained below:
- The weak form: This degree of market efficiency is of the assumption that future price rates are in no way influenced by the past price movement. In other words, past price trends have no effect on how future prices will trend. As a result of this assumption, the rule that some investors would purchase or sell their stock is totally invalid.
- The semi-strong form: This form of market efficiency is of the assumption that stocks in the market usually adjust fast so that it can absorb the most recent public information, to ensure that investors benefits do not exceed the market when they trade on that recent information.
- The strong form: This form of market efficiency assumes that both public and private information is reflected in the market prices. This assumption incorporates the other two forms (weak form and semi-strong form). Following the assumption that both private and public information is reflected in the stock prices, none of the investors profit will exceed that of an average investor even if they had exposure to inside (private) information.
How Market Become Efficient
To be able to make a market efficient, it is essential for investors to look at the market as inefficient and with the possibility of beating it. Only then can the market be efficient. However, it is ironic that the strategies for investment supposed to take advantage of inefficiencies are the ones instead of helping to maintain market efficiency.
Arguments Against Market Efficiency
Like any other theory, it is obvious that there exist arguments against the efficient market hypothesis. Those who argue against EMH say that there are investors who have been able to beat the market. They focused their investment strategy on undervalued stocks and were able to make billions of dollars. The argument further reflects on the portfolio managers with good track records than their counterparts, and also to the investment houses whose research analysis are well-known compared to others. For these reasons, some have been able to conclude that there is no way the performance can be random when we have individuals who have been able to profit and at the same time beat the market. However, following the law of probability, there are those who strongly believe that in a market with many investors, there are bound to be those who will outperform the market while others will underperform. This then nullifies the assumption that investors who beat the market, do so not because they have the skills, but rather because they happen to be lucky. Nonetheless, behavioral finance studies have revealed that when it comes to stock prices, there are some biases. Some of the bias includes confirmation, overconfidence, and loss aversion.