What Is Market Efficiency?

What Is Market Efficiency?

When money is put into the stock market, it is done to generate a return on the capital invested. Many investors try not only to make a profitable return but also to outperform or beat the market.

Efficient market hypothesis at any given time, prices fully reflect all available information on a market. Thus, no investor has a benefit in predicting a return on a stock price since no one has access to information not already available to everyone else. In an efficient market buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

According to Fama, Efficient market is a market which adjusts rapidly to new information. It is a market in which prices fully reflect available information. (Fama, 1969)

If the market is efficient, news about the stock should be reflected immediately in the price.

The EMH is associated with the idea of a "random walk," which implies that the next move of the speculative price is independent of all past moves or events, so historic prices are of no value in predict future prices.

Random Walk Theory

Random walk occurs when there is no correlation between one movement and subsequent ones. For example in case of price of shares -one day's price change cannot be predicted by looking at previous day's price change because the present price movements are independent of successive movements.

A Random walk occurs because the share price at any one time reflects all available information and it will only change if new information arises.

How Does a Market Become Efficient?

In order for a market to become efficient, investors must recognize that a market is inefficient and possible to beat. A market has to be large and liquid. Information has to be extensively available in terms of accessibility and cost, and released to investors at more or less the same time. Transaction costs have to be cheaper than the expected profits of an investment strategy. Most importantly, an investor has to believe that she or he can outperform the market.

Degrees of Efficiency

Weak form efficiency - All past prices of a stock are reflected in today's stock price. Hence, technical analysis cannot be used to predict and beat a market. It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows".

Semi-Strong Efficiency - Share prices fully reflect all the relevant publicly available information. This includes not only past price movements but also earnings and dividend announcements, right issues, resignations of directors and so on. Neither fundamental nor technical analysis can be used to achieve superior gains. It also implies that no one should be able to outperform the market using something that "everybody else knows".

Strong Efficiency - It states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage.

Keane theory

According to the theory

Authentication - The opportunity to exploit inefficiencies should be genuine that is should not arise from some error or mistake or from cheating others. For e.g. because of wrong publishing of some report or document.

Identifiably may imply that the opportunity must manifest itself and visible enough to consider it as an opportunity.

Materiality - The opportunity can be successfully exploits if it is practically feasible and not obey theoretically.

On paper the opportunity may be feasible but in actual reality it may fail to materialize because suppose transaction cost and other external factors like supply & demand of securities may create practical hurdles in exploiting market efficiencies

Persistency - The opportunity must be persistent and not a one time event. It should have precedence and not a standalone event.

Anomalies

Despite strong evidence that the stock market is highly efficient, there have been scores of studies that have documented long-term historical anomalies in the stock market that seem to contradict the efficient market hypothesis.

These anomalies could be because of three reasons:

* Financial markets are efficient, but we have not observed enough data to actually categorize these effects as anomalies. These anomalies are runs of purely good luck. This means that the ling run is really good and we have to wait a thousand years before we make any statements trashing efficient market hypothesis.

* Financial markets are efficient, the data we have is enough to make a judgment, however we do not know how to risk-adjust these returns yet. That is, we do not actually have a good assets pricing model.

* Financial markets are inefficient.

Technical Anomalies

'Technical Analysis' is a general term for a number of investing techniques that attempt to forecast securities prices by studying past prices and related statistics.

The majority of researchers that have tested technical trading systems (and the weak-form efficient market hypothesis) have found that prices adjust rapidly to stock market information and that technical analysis techniques are not likely to provide any advantage to investors who use them. Transactions costs also reduce or eliminate any advantage from technical anomalies.

Types of Technical Rules

* Moving Averages- Buy and sell signal were generated by a long and short moving average crossing. Moving averages of 50, 150 and 200 days with short averages of 1, 2 and 5 days were tested. The results - "All the buy-sell differences are positive and the t-tests for these differences are highly significant..."