Markets are said to be efficient if the market price is an unbiased estimate of the true value of the investment. It means that a market that is over pricing all assets has become inefficient. Market efficiency can go up or down from time to time. An efficient capital market has the following features:
- Operational efficiency– low transaction cost and transaction should be quickly completed.
- Pricing efficiency: prices should fully and fairly reflect all information.
- Allocational efficiency: capital market through the medium of pricing efficiency allocates the funds where they are best used.
There are three different levels or forms of efficiency.
- 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. In such markets abnormal return can not be made by studying available company information and fundamental analysis 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’.
Market efficiency has many interesting implications:
- In an efficient market, equity research would provide no benefits.
- 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.
- In an efficient market, a strategy of minimizing trading would be superior to a strategy that required frequent trading.
It is interesting to note what market efficiency does not imply:
- 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.
- No investor will ‘beat’ the market in any time period. To the contrary, approximately half of all investors should beat the market in any period.
- 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.