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.

 

Efficient Market Response – The reaction of new information on a stock price in efficient and inefficient markets

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.