Lets pick up from yesterday post. Empirical tests of the efficiency of capital markets have examined the extent to which the prices of securities reflect relevant information, i.e. pricing efficiency, because of lack of data for testing allocational and operational efficiency. Many studies have examined the extent to which it is possible to make abnormal return in excess of expected returns.

Markets are said to be “weak form efficient” if current security price reflect all past movements of share prices. It means it is not possible to make abnormal returns by studying past share price movements using Technical Analysis in such a market is not of any use.

Markets are said to be “semi strong form efficient” if security price reflect all historical information and all publicly available information, and react quickly and accurately to any new information as it becomes available. It means that in a market which is semi strong form efficient abnormal return can not be made by studying available company information and fundamental analysis as such can not give us abnormal returns.

Markets are said to be “strong form efficient” if share price reflect all information whether it is publicly available or not. If markets are strong form efficient then no one can make abnormal returns from share dealing, not even people who are able to act upon ‘insider information’. Capital markets do not satisfy all conditions for strong form efficiency, as some people do manage to make abnormal returns through insider dealing, as witnessed by some highly publicised prosecutions.

Implications of market efficiency

An immediate and direct implication of an efficient market is that no group of investors should be able to consistently beat the market using a common investment strategy. An efficient market would also carry very negative implications for many investment strategies and actions that are taken for granted –

  • In an efficient market, equity research and valuation would be a costly task that provided no benefits. The odds of finding an undervalued stock should be random (50/50). At best, the benefits from information collection and equity research would cover the costs of doing the research.
  • In an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy, that created larger information and execution costs. There would be no value added by portfolio managers and investment strategists.
  • In an efficient market, a strategy of minimizing trading, i.e., creating a portfolio and not trading unless cash was needed, would be superior to a strategy that required frequent trading.

 What market efficiency does not imply:

  1. Stock prices cannot deviate from true value; in fact, there can be large deviations from true value. The only requirement is that the deviations be random.
  2. No investor will ‘beat’ the market in any time period. To the contrary, approximately half of all investors, prior to transactions costs, should beat the market in any period.
  3. No group of investors will beat the market in the long-term. Given the number of investors in financial markets, the laws of probability would suggest that a fairly large number are going to beat the market consistently over long periods, not because of their investment strategies but because they are lucky. It would not, however, be consistent if a disproportionately large number of these investors used the same investment strategy.
In an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long-term, though there may be deviations from these expected returns in the short-term. Against such bold statements it is interesting to note what Warren Buffet, the legendary investor has to say about EMH. Buffet, does not support EMH and as an analyst and investor, claims advantage when the competition (believing in EMH) has already conceded that they could not do better than others.

Necessary conditions for market efficiency

Markets do not become efficient automatically. It is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that make markets efficient. The necessary conditions for a market inefficiency to be eliminated are as follows –

(1)   The market inefficiency should provide the basis for a scheme to beat the market and earn excess returns. For this to hold true –

  1. The asset (or assets) which is the source of the inefficiency has to be traded.
  2. The transactions cost of executing the scheme have to be smaller than the expected profits from the scheme.

(2)   There should be profit maximizing investors who

  1. recognize the ‘potential for excess return’
  2. can replicate the beat the market scheme that earns the excess return
  3. have the resources to trade on the stock until the inefficiency disappears