Topics Covered
- What Is Market Efficiency?
- KEY TAKEAWAYS
- Market Efficiency Explained
- Differing Beliefs of an Efficient Market
- CONCLUSION
What Is Market Efficiency?
The degree to which market prices accurately reflect all available, pertinent information is referred to as market efficiency. There is no way to “beat” the market if markets are efficient since there are no assets that are undervalued or overvalued because all information is already factored into prices.
The phrase was coined by economist Eugene Fama in a 1970 paper, however, Fama admits that the phrase is a little deceptive because no one is really certain how to define or measure this concept of market efficiency. Despite these restrictions, the phrase is used to refer to the efficient market theory, which is what Fama is most famous for (EMH).
According to the EMH, it is impossible for an investor to outperform the market, and market anomalies shouldn’t exist since they would be quickly arbitraged away. For his contributions, Fama later received the Nobel Prize. Investors that embrace this notion frequently invest in index funds that follow the performance of the entire market and advocate for passive portfolio management.
The ability of markets to absorb information that gives buyers and sellers of securities the greatest number of opportunities to execute transactions without raising transaction costs is the essence of market efficiency. Academics and practitioners disagree sharply on whether or to what extent markets, including the U.S. stock market, are efficient.
KEY TAKEAWAYS
- Market efficiency is the degree to which current prices accurately represent all pertinent and available information regarding the true worth of the underlying assets.
- Since all information that is available to traders is already factored into the market price, a truly efficient market makes it impossible to outperform the market.
- The market becomes more efficient as the quality and quantity of information rise, lowering prospects for arbitrage and above-market gains.
Market Efficiency Explained
Three levels of market efficiency exist. Because it is impossible to accurately estimate future prices based on historical price changes, market efficiency is weak. If current prices take into account all relevant information that is currently known, then all knowledge that can be learned from past prices is already taken into account by current prices. Future price changes can only result from the availability of fresh information, therefore.
According to this version of the hypothesis, it is not reasonable to anticipate that investing techniques like momentum or any rules based on technical analysis will consistently produce above-average market returns. This version of the hypothesis still leaves open the potential that by employing fundamental analysis, excess returns could be obtained.
The semi-strong form of market efficiency assumes that stocks quickly adjust to taking in new information that is made public, making it impossible for an investor to outperform the market by trading on that knowledge. Because any knowledge gleaned from the fundamental analysis will already be available and hence already incorporated into current pricing, it follows that neither technical analysis nor fundamental analysis would be trustworthy tactics to attain greater returns. To acquire a trading advantage, only private information that is not available to the general market will be relevant, and only to those who have it before the rest of the market does.
The strong form of market efficiency, which builds on and incorporates the weak form and the semi-strong form, claims that market prices reflect all information, both public and private. Assuming that stock prices represent all information, both public and private, no investor, including a company insider, would be able to gain an advantage over the average investor even if he had access to fresh insider knowledge.
Differing Beliefs of an Efficient Market
The strong, semi-strong, and weak forms of the EMH show the vast range of opinions held by academics and investors regarding the market’s actual efficiency. Strong form efficiency proponents concur with Fama, and they frequently include passive index investors. Active trading can produce anomalous profits through arbitrage, according to proponents of the weak version of the EMH, whereas semi-strong believers fall somewhere in the middle.
Value investors, for instance, are at the other end of the spectrum from Fama and his adherents and hold the opinion that stocks can become undervalued or priced below what they are really worth. By buying stocks when they are undervalued and selling them when their price increases to match or above their real worth, successful value investors can profit.
People who reject the idea of an efficient market emphasise the existence of active traders. There should be no incentive to become an active trader if there are no opportunities to make profits that outperform the market. Furthermore, because the EMH states that an efficient market has minimal transaction costs, the fees levied by active managers are considered as evidence that the EMH is incorrect.
CONCLUSION
Despite the fact that some investors support the EMH on both sides, there is concrete evidence that greater financial information dissemination has an impact on stock prices and improves market efficiency.
For instance, with the adoption of the Sarbanes-Oxley Act of 2002, which mandated increased financial openness for publicly traded corporations, equities market volatility decreased. Financial statements were discovered to be more credible, increasing the information’s dependability and boosting confidence in a security’s stated price. The reactions to earnings announcements are lessened since there are fewer surprises.
This alteration in volatility pattern demonstrates how the market became more effective after the Sarbanes-Oxley Act was passed and its information requirements. This supports the EMH by showing that enhancing the accuracy and dependability of financial accounts can reduce transaction costs.
Other instances of efficiency occur when alleged market irregularities become well-known and then vanish. For instance, in the past, when a stock was first added to an index like the S&P 500, its share price would increase significantly only because the stock was now a component of the index, regardless of any new developments in the company’s fundamentals. This index effect anomaly was extensively noticed and made public as a result, and it has since mostly vanished. Thus, as information improves, markets become more effective and anomalies become less common.