In the most efficient of markets, profits are assumed to be random and information obtained in the market should not be a factor in determining stock returns. However, that is not the case, so what does the theory of efficient markets imply for investors trying to be successful in the market?foto: Anna Nekrashevich
In the most efficient of markets, profits are assumed to be random and information obtained in the market should not be a factor in determining stock returns. However, that is not the case, so what does the theory of efficient markets imply for investors trying to be successful in the market?
What is market efficiency?
A market is said to be efficient if the price, say of a stock or an index, moves in such a way that it is completely random. This is true when all new information to the market is unpredictable and cannot be exploited for profitability purposes due to changing demand and supply conditions. Conversely, if a market is not efficient, the information obtained in the market is not unpredictable and significant patterns in the data can be exploited to generate abnormal profits.
When is a market efficient?
The term “market efficiency” is often split into three different meanings, where each part has to be satisfied for the market to be fully efficient:
⋅ Operational efficiency: If the market is operationally efficient, trading can occur quickly and reliably and market liquidity and transaction cost are not a problem.
⋅ Allocation efficiency: If the capital flows the most effective producer, ie., does more efficient firms obtain more capital than less efficient firms on the market.
⋅ Informational efficiency: Prices reflect all relevant information on the market.
All of these points play a significant role, the first two are mostly connected to the functionality of the market which is often based on market structure. Informational efficiency is the most common one that investors are interested in when discussing market efficiency.
The Efficient Market Hypothesis
The efficient market hypothesis makes use of informational efficiency and is the theory that has the most impact on traders, given that they trade in already functional markets. The efficient market hypothesis is just a hypothesis of the informational efficiency condition: all prices in the stock market already incorporate the best current information.
One common misconception about the efficient market hypothesis is that all traders are rational and well-informed, ie., spend their funds in a way that maximizes their chances of profits. Instead, the only requirement is that there are sufficiently many market professionals that are able to change supply and demand conditions when new information becomes available in the market. For this to be true, it is clear that the operational efficiency and allocation efficiency conditions are satisfied, otherwise, there would be problems with changing the supply and demand conditions, and hence the price would not reflect the current information.
Market efficiency and investors possibilities to predict the market
In reality, a market can be efficient but still render possibilities for investors to use information that is on the market but has not been incorporated in the price. Since information often is hard to come by, skilled investors can use the disparity in skill and exploit possible information for their own profit. That is why a market has three different layers of efficiency:
1. Weak form efficiency: If the market is weak-form efficient, investors cannot use historical data (technical analysis) to predict the market.
2. Semi-strong efficiency: If a market exhibits semi-strong efficiency investors cannot use historical data, nor, use fundamental analysis (use recently published financial papers, reports, news, etc.,) to predict the market.
3. Strong form efficiency: If a market is strong-form, institutional investors (hedge funds, investment firms) cannot use current private information to predict the market.
So, according to the efficient market hypothesis, investors trying to become successful in the market should invest in markets that are inefficient on the level interesting for their particular strategy. However, in the stock market, the level of efficiency is not necessarily persistent for all stocks, meaning that investors may exploit inefficiencies for certain stocks. This is certainly true if there are various markets segments within a larger market. In Sweden, for instance, the probability of finding inefficient stocks is higher if the firms are small-cap than large-cap. Although, some small-cap stocks may experience liquidity problems, which makes it hard to trade fast which may be the reason for the apparent inefficiencies.