Efficient Market

MARKET EFFECIENCY

Definition: The degree to which stock prices reflect all available relevant information is known as market efficiency. Eugene Fama contributions:

Efficient Market
Market where all pertinent information is available to all participants at the same time, and where prices respond immediately to available information. Stock markets are considered the best examples of efficient markets

Requirements of market efficiency:

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
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. 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 overvalued stocks using any investment strategy.

Basic Characteristics of Efficiency

1. 2. 3. 4.

Act to new information rapidly and accurately Price movement is unpredictable No trading strategy constantly beat the market Investment professionals not that professional

Market efficiency types

1. Information arbitrage efficiency

2. Fundamental valuation efficiency

3. Full insurance efficiency 4. Functional/Operational efficiency 5. Allocative Efficiency

Dimensions of Market Efficiency

1.

The type of information incorporated into price (which information is available?). 2. The speed with which new information is incorporated into price (how fast information is reflected?). What efficient market does not imply:

1. Stock prices cannot deviate from true value 2. No investor will 'beat' the market in any time period 3. No group of investors will beat the market in the long term

Market Efficiency for Investor Groups

Market efficiency needs to be specific with respect to market considered as well as the investor group covered as it is impossible to assume that all markets are efficienr to all investors.The specification, thereby leads to much more accurate results.

Efficient Market Hypothesis (EMH)

Definition : Eugene fama states: an efficient market, i.e., a market that adjusts rapidly to new information Fama et al. (1969) states: A market in which prices always fully reflect available information is called efficient. Grossman and Stiglitz (1980) states I take the Market Efficiency Hypothesis to be the simple statement that security prices fully reflect all available information. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0. Jenson (1978) states: Prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs.

The acumen behind EMH can be described as; First, investors care about whether various trading strategies can earn excess returns (i.e., beat the market). Second, if stock prices accurately reflect all information, new investment capital goes to its highest-valued use.

Keyness emphasis on the speculative nature of stock prices led many to believe that stock markets have little or no essential economic role; Many economists during the Great Depression and the immediate postWorld War II era emphasized government-directed capital investment; and The modern corporation, and the resulting need to raise large sums of capital, was a relatively recent development. But the invention of computing power in the 1950s, which made rigorous empirical analysis with large data sets more feasible, brought renewed attention from academic researchers

Market Efficiency Levels

Criticism on EMH

First, over shorter horizons, such as days, weeks, or months, there is considerable evidence that the EMT can explain the direction of stock price changes. That is, the response of stock prices to new information reasonably approximates the change in the intrinsic value of equity.

Second, the EMT serves as a benchmark for how prices should behave if capital investments and other resources are to be allocated efficiently. Just how close markets come to this benchmark depends on the transparency of information, the effectiveness of regulation, and the likelihood that rational arbitragers will drive out noise traders. In fact, the informational efficiency of stock prices varies across markets and from country to country.

Anomalies of market efficiency:

A market anomaly (or market inefficiency) is a price and/or rate of return distortion on a financial market that seems to contradict the efficient market hypothesis. There are many market anomalies; some occur once and disappear, while others are continuously observed.

Various Types Of Anomalies

Calendar Effects Anomalies that are linked to a particular time are called calendar effects

1. Weekend Effect
The weekend effect describes the tendency of stock prices to decrease on Mondays, meaning that closing prices on Monday are lower than closing prices on the previous Friday

2. Turn-of-the-Month Effect: The turn-of-the-month effect refers to the tendency of stock prices to rise on the last trading day of the month and the first three trading days of the next month. 3.Turn-of-the-Year Effect: The turn-of-the-year effect describes a pattern of increased trading volume and higher stock prices in the last week of December and the first two weeks of January. 4. January effect Small-company stocks outperform the market and other asset classes during the first two to three weeks of January. This phenomenon is referred to as the January effect.

Announcements and Anomalies

Stock Split Effect: Short-Term Price Drift: Earnings Reports

Before and after a company announces a stock split, the stock price normally rises. The increase in price is known as the stock split effect

Short-term price drift occurs when stock price movements related to the announcement continue long after the announcement.

It has been shown that an investor can profit from investing immediately when a company reports because it takes time for the market to absorb the new information. This goes against the EMH

Announcements and Anomalies: (contd)

Price-Earnings Ratio Size Effect Neglected Firms Low Book to market ratio

Investing using the P/E ratio valuation metric has been an anomaly against the EMH. It has been shown that investors can profit by investing in companies with a low P/E ratio.

Going against EMH, it has been shown that smaller companies, on a risk-adjusted basis, have greater returns their larger peers

Neglected firms are firms that Wall Street analysts deem too small to cover. Although, these firms tend to generate larger levels of return, negating the EMH.

Stocks with below-average price-to-book ratios tend to outperform the market.

Behavioral Finance

Behavioral finance take into account how real (different) people make decisions, irrationalities may arise because investors dont always process information correctly, and hence derive incorrect future distributions of returns ,arbitrage opportunities even knowing the true distribution of returns, investors can make suboptimal decisions

Behavioral finance view of markets and market efficiency is based on following propositions:

Forecasting Errors

People tend to give too much weight to recent experience compared to prior beliefs

Over confidence

People tend to overestimate the precision of their predictions and their abilities. A study shows that over confident individual investors tends to trade more than other investors, with resulting investment performance is below than average investors

The framing concept

The way a problem is presented ( framing) significantly affects the decision that is made

Herding effect:

Various individual investors tends to invests similarly which enforces a self reinforce herding effect

Regret Avoidance

If decisions turn out bad, individuals regret more the unconventional decisions (e.g., blue chips)

Mental Accounting

Investors tend to separate their decisions for different accounts rather than regard their holdings as one portfolio
Investors are too slow to update their beliefs in response to recent evidence (gradual adjustment)

Conservatism

Conclusion Financial market efficiency is an important topic in the world of Finance. While most financiers believe the markets are neither 100% efficient, nor 100% inefficient, many disagree where on the efficiency line the world's markets fall. It can be concluded that in reality a financial market cant be considered to be extremely efficient, or completely inefficient. The financial markets are a mixture of both, sometimes the market will provide fair returns on the investment for everyone, while at other times certain investors will generate above average returns on their investment