Market efficiency

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to “beat” the market because there are no undervalued or overvalued securities available.

The term was taken from a paper written in 1970 by economist Eugene Fama, however Fama himself acknowledges that the term is a bit misleading because no one has a clear definition of how to perfectly define or precisely measure this thing called market efficiency. Despite such limitations, the term is used in referring to what Fama is best known for, the efficient market hypothesis (The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.

Because the EMH is formulated in terms of risk adjustment, it only makes testable predictions when coupled with a particular model of risk. As a result, research in financial economics since at least the 1990s has focused on market anomalies, that is, deviations from specific models of risk. EMH).

Features of an Efficient Market

• An efficient market allows investors an opportunity to outperform.
• In a truly efficient market, the prices of securities reflect all relevant information about the asset, including historical data such as price, volume and more.
• With the disclosure of new information, the efficiency of the market increases, diminishing the opportunities for excess returns and arbitrage.
• It’s important to note that market efficiency does not suggest that the price of security is its true intrinsic value. It only states that market participants cannot predict the future price of an asset on a consistent basis.

Types of Market Efficiency

Strong form

This form of market efficiency theory states that market prices of securities reflect public and private information both. Consequently, investors will not be able to beat the market by trading on any private information since all such information will already be factored into the market prices of the securities.

Semi-strong form

In a semi-strong variation of an efficient market, the current prices of securities represent all information that is publicly available. It includes historical information like price, volume and more. This form of theory assumes that securities make quick adjustments in response to any newly available information. Thus, traders won’t be able to outperform the market by trading on such information.

It dismisses both technical and fundamental analysis since any information gathered by using these techniques will already be available to other investors. Only private information that is unavailable in the market would be useful for an investor to have the edge over others.

Weak form

This form of market efficiency theory suggests that current market prices of securities reflect their previous or historical prices. Thus, it means that market participants who are buying and selling securities by analysing their historical data should earn normal returns. Hence, any new price changes in future can only take place if new information becomes publicly available.

Differing Beliefs of an Efficient Market

Investors and academics have a wide range of viewpoints on the actual efficiency of the market, as reflected in the strong, semi-strong, and weak versions of the EMH. Believers in strong form efficiency agree with Fama and often consist of passive index investors. Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage, while semi-strong believers fall somewhere in the middle.

For example, at the other end of the spectrum from Fama and his followers are the value investors, who believe stocks can become undervalued, or priced below what they are worth. Successful value investors make their money by purchasing stocks when they are undervalued and selling them when their price rises to meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that active traders exist. If there are no opportunities to earn profits that beat the market, then there should be no incentive to become an active trader. Further, the fees charged by active managers are seen as proof the EMH is not correct because it stipulates that an efficient market has low transaction costs.