Stock market efficiency
The theory of an efficient market has captivated the minds
of investors for years. For many investors their money is put into the stock
market not only to generate a return on the money they've invested, but also to
try to outperform, or beat, the market.
However, Eugene Fama (1970) theorised stock market efficiency.
The efficient market hypothesis (EMH) suggests that the above paragraph is
false, that it is not possible for investors to ‘beat the market’, as stock
prices at any moment reflect all available information. The hypothesis states that if any new information becomes available the prices will adjust instantly and
rationally, which is why it would be extremely difficult for investors to ‘beat
the market’ unless they have insider information.
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Degrees of Efficiency
Fama created a grading system with three classifications in
order to define the extent to which markets were efficient.
Strong-form
efficiency – This states that all relevant information is available in a
market, whether it is public or private. In this type of market it is not possible
to make abnormal profits, not even insider traders.
Semi-strong form
efficiency – This states that share prices reflect all the relevant
information which is available publicly but not privately. This level suggests
that there is no advantage to be had by using this information as the market
will already have accounted for it in its share price.
Weak-form efficiency
– This type claims that all past prices of a share are reflected in today's share price. Therefore, technical analysis is pointless to try and predict the
future.
In an efficient market prices become random not predictable,
so it is difficult for investors to spot any past patterns or trends to predict
future movement. This is known as a random walk. This analogy suggests that
price changes are similar to a drunken person walking down a road, in that they
both follow a random walk, or in a more technical manner, there is no
systematic correlation between one movement and subsequent ones. So why does
this occur? It occurs because the share
prices at any one time reflects all known information and it will only change
when new information becomes available, when new information arrives it is
unknown if it will be good or bad.
In the real world, markets cannot be absolutely efficient or
wholly inefficient. It might be reasonable to see markets as essentially a
mixture of both, as decisions and events are not always truly reflected
immediately, or not at all with regards to insider information, into a share
price. If the market was to be 100% efficient there wouldn’t be investors
trying to seek or uncover information in order to achieve huge profits by trading the market (Grossman & Stiglitz, 1980)
However, markets across the globe are gaining greater
efficiency. Mainly through the use of information technology which allows for a
more effective and faster means to broadcast information, and electronic
trading allows for prices to adjust more quickly to news entering the market.
References
Fama, E. (1970) "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance. 25:2, pp. 383-417.
Grossman,J. and Stiglitz, J. (1980) On the Impossibility of Informationally Efficient Markets. American Economic Review. 70:3, pp. 393-408.
References
Fama, E. (1970) "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance. 25:2, pp. 383-417.
Grossman,J. and Stiglitz, J. (1980) On the Impossibility of Informationally Efficient Markets. American Economic Review. 70:3, pp. 393-408.
