Question

Your opinion about the extent to which markets are efficient will have a significant impact on your choice re effective trading strategies. Briefly explain why and how this is true.

Answer 1

The extent to which markets are efficient has a great signifiance for the choice of effective trading strategies.

1. The capital asset pricing models consider markets to be efficient which means asset prices are expected to reflect the true intrinsic value of the assets. This means no investor can consistently beat the market returns. In other words, no investment strategies can be of any value in an efficient market. To put it more bluntly, even fundamental analysis based investments have no value as the prices are expected to instantaneously reflect the true value of assets. In reality, markets are not efficient and we have historical evidences as to how fundamental analysis have given significant market returns or multi-baggers have always been part of market phenomena.

2. The above contention is not about any one particular market being efficient or inefficient but the theoretical possibility of any market being efficient. The reality is that no market can be or is efficient in the real world.

3. Efficiency is classified in to three types: Weak, semi-strong and strong. In the case of weak, all past prices are incorporated into the market prices. In the case of semi-strong form, all publicly available information are already incorporated iin asset prices while the strong form of efficiency requires even private informtion to be instantaneously incorporated in the asset prices. In terms of market comparison, we can say some markets are more efficient in terms of 'weak and semi-strong' form than others. To that extent, some markets may provide more profit opportunities than others.

4. However, no market can be truly efficient in the strong form that can make even fundamental analysis useless as prices (including projected future values) required to be immediately incorporated as soon as new information emerges. Value investing is still a great strategy in most markets.

5. With respect to short term investment strategies i.e. Trading strategies referred in the question, they should be useless even if the markets are efficient in weak form. Most of the technical analyses based strategies rely on past information on prices. However, weak form negates any possibility of unearthing any useful information from past historical stock price data.

6. However, technical analysis is still a main-stay for many active traders who are able to make signifiant profit inspite of brokerage and transaction costs. This indicates markets are not truly even weakly efficien even in advanced and developed stock markets.

7. As per some academic experts, even when markets are efficient, the stock prices need not always reflect true value and it is enough if they are unbiased estimates. This means the stock prices can randomly move around the instrinsic value. With this definition of market efficiency, even if markets are efficient, we still have possibility of making profit from good and effective trading strategies as markets are expected to behave randomly around true values.

8. In other words, while the principal assumption of market efficiency theories that all investors will have all information and will have same expectations is non-sensical and impractical in real world, the eventual adjustment of prices to reflect the intrinsic value of the asset - whether instantaneously and always OR over a period of time - has to come through trading of market participants. Since there can be gaps in information and inefficiency, there will always be possibilities of making profits through trading strategies.

9. In the real world, the market efficiency is achieved by trading and investment strategies of market participants where markets are not anywhere beyond 'weak" and to some extent 'semi-strong' form efficient and that every market participation can give some profits and other losses. Hence, we find in real world, investors making profits through trading and investment strategies.

10. To conclude, in the real world, if the markets are efficient, then no trading or investment strategy can be of anyuse. However, in reality, markets are inefficient, and there are always possibility of making excess market returns and positive alphas. There are real life evidences of value investors like Warren Buffet making great profits and efficiently managed mutual funds making over the market returns. Similarly, as markets get more and more efficient in weak form with more trading, newer strategies are being devised by traders who continue to make their living with market trading strategies.