Question

What is an efficient market? Explain three forms of market efficiency.

Answer 1

EFFICIENT MARKET

Efficient Market 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 Efficient market states that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this theory tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

There are three degrees of market efficiency. -

The weak form of market efficiency is that past price movements are not useful for predicting future prices. If all available, relevant information is incorporated into current prices, then any information relevant information that can be gleaned from past prices is already incorporated into current prices. Therefore future price changes can only be the result of new information becoming available.

Based on this form of the hypothesis, such investing strategies such as momentum or any technical-analysis based rules used for trading or investing decisions should not be expected to persistently achieve above normal market returns. Within this form of the hypothesis there remains the possibility that excess returns might be possible using fundamental analysis. This point of view has been widely taught in academic finance studies for decades, though this point of view is no long held so dogmatically.

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information. This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns, because any information gained through fundamental analysis will already be available and thus already incorporated into current prices. Only private information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does.

The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form. Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information.