What is an efficient market?
(a) Market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased, i.e., that prices can be greater than or less than true value, as long as these deviations are random.
(b) The fact that the deviations from true value are random implies, in a rough sense, that there is an equal chance that stocks are under or over valued at any point in time, and that these deviations are uncorrelated with any observable variable. For instance, in an efficient market, stocks with lower PE ratios should be no more or less likely to under valued than stocks with high PE ratios.
(c) If the deviations of market price from true value are random, it follows that no group of investors should be able to consistently find under or over valued stocks using any investment strategy.
Market Efficiency for Investor Groups
- Under weak form efficiency, the current price reflects the information contained in all past prices, suggesting that charts and technical analyses that use past prices alone would not be useful in finding under valued stocks.
- Under semi-strong form efficiency, the current price reflects the information contained not only in past prices but all public information (including financial statements and news reports) and no approach that was predicated on using and massaging this information would be useful in finding under valued stocks.
- Under strong form efficiency, the current price reflects all information, public as well as private, and no investors will be able to consistently find under valued stocks.
Implications of market efficiency
(a) 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.
(b) 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.
(c) 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:
An efficient market does not imply that -
(a) 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.
(b) 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.
(c) 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.
Necessary conditions for market efficiency
(1) The market inefficiency should provide the basis for a scheme to beat the market and earn excess returns. For this to hold true -
(a) The asset (or assets) which is the source of the inefficiency has to be traded.
(b) The transactions costs of executing the scheme have to be smaller than the expected profits from the scheme.
(2) There should be profit maximizing investors who
(a) recognize the 'potential for excess return'
(b) can replicate the beat the market scheme that earns the excess return
(c) have the resources to trade on the stock until the inefficiency disappears
Efficient Markets and Profit-seeking investors: The Internal Contradiction
Propositions about market efficiency
Proposition 1: The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. To the extent that investors have difficulty trading on a stock, either because open markets do not exist or there are significant barriers to trading, inefficiencies in pricing can continue for long periods.
Proposition 2: The probability of finding an inefficiency in an asset market increases as the transactions and information cost of exploiting the inefficiency increases. The cost of collecting information and trading varies widely across markets and even across investments in the same markets. As these costs increase, it pays less and less to try to exploit these inefficiencies.
Initial Public Offerings: IPOs supposedly make excess returns, on average.
Emerging Market Stocks: Do they make excess returns?
Investing in 'loser' stocks, i.e., stocks that have done very badly in some prior time period should yields excess returns. Transactions costs are likely to be much higher for these stocks since-
(a) they then to be low priced stocks, leading to higher brokerage commissions and expenses
(b) the bid-ask becomes a much higher fraction of the total price paid.
(c) trading is often thin on these stocks, and small trades can cause prices to move.
Corollary 1: Investors who can estabish a cost advantage (either in information collection or transactions costs) will be more able to exploit small inefficiencies than other investors who do not possess this advantage.
Proposition 3: The speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the ineffficiency can be replicated by other investors. The ease with which a scheme can be replicated itselft is inversely related to the time, resouces and information needed to execute it. Since very few investors single-handedly possess the resources to eliminate an inefficiency through trading, it is much more likely that an inefficiency will disappear quickly if the scheme used to exploit the inefficiency is transparent and can be copied by other investors.