Market efficiency
Kevin C.H. Chiang
Efficient market
(Informationally) efficient market: a market in
which security prices adjust fully and rapidly
to the arrival of new information and,
therefore, the current prices of securities fully
reflect all available information about the
security.
3 sufficient conditions for an efficient
market (Fama)
A large number of competing profit-
maximizing participants analyze and value
securities, each “independent” of the others.
New information comes in a “random”
fashion.
The competing investors attempt to adjust
security prices rapidly to reflect the effect of
new information.
3 forms of market efficiency, I
Weak form: prices reflect all information
contained in the history of past trading.
Question: do past returns and prices predict
future returns?
3 forms of market efficiency, II
Semi-strong form: prices reflect all publicly
available information (earnings, dividends,
PE ratios, book-to-market ratios, political
news, etc.)
Question: how quickly do prices reflect all
public information?
3 forms of market efficiency, III
Strong form: prices reflect all relevant
information, including inside information.
Question: Do insiders make abnormal
returns?
Testing
Does a known strategy produce consistently
abnormal returns after adjusting for
investment risk and transaction costs?
No: the market is quite efficient.
Yes: evidence against the EMH.
Implications, I
In an efficient market, technical analysis is
useless.
In a semi-strong form efficient market,
fundamental analysts (country analysts,
industry analysts, and company analysts), on
average, will not outperform the market.
Implications, II
In a semi-strong form efficient market,
fundamental analysis is useless.
In this market, a portfolio manager should:
(1) determine a proper level of risk tolerance,
(2) form a portfolio consisting of the risk-free
asset and a well-diversified risky portfolio
(passive management), and (3) minimize
taxes and total transaction costs.
Passive management
No attempt to find undervalued securities.
No attempt to time.
Hold a well-diversified portfolio.
Active management/selection
Believe that one can beat the market.
Find undervalued securities.
Time the market.
Alternative view: The Challenge to
Efficiency
“In the real world of investment, however, there are
obvious arguments against the EMH. There are
investors who have beaten the market - Warren
Buffett, whose investment strategy focuses
on undervalued stocks, made millions and set an
example for numerous followers. There are portfolio
managers that have better track records than others,
and there are investment houses with more
renowned research analysis than others. So how
can performance be random when people are clearly
profiting from and beating the market?”
Does this argument make sense?
Source: Investopedia.com.