Market Efficiency Explained Differing Opinions and Examples
Market Efficiency: Opinions and Examples
Market efficiency refers to market prices reflecting all available, relevant information. If markets are efficient, there are no undervalued or overvalued securities.
The term originated from a 1970 paper by economist Eugene Fama. However, Fama himself acknowledges the lack of a precise definition or measurement of market efficiency. Despite this limitation, it is commonly associated with Fama’s efficient market hypothesis (EMH).
According to the EMH, investors can’t outperform the market, and anomalies will be arbitraged away. Fama won the Nobel Prize for his work. Supporters of this theory tend to buy index funds and prefer passive portfolio management.
Key Takeaways:
– Market efficiency reflects the value of underlying assets.
– A truly efficient market eliminates the possibility of beating it.
– As information increases, markets become more efficient.
Market efficiency is the ability of markets to incorporate information and facilitate transactions. The degree of efficiency in markets like the U.S. stock market is a topic of debate.
There are three degrees of market efficiency. In the weak form, past price movements are not useful for predicting future prices. Therefore, momentum or technical-based strategies are not expected to beat the market consistently.
The semi-strong form assumes stocks adjust quickly to new public information, rendering technical and fundamental analysis unreliable. Only private information can provide an advantage.
The strong form states market prices reflect all information, including private information, leaving no opportunities for profit.
Beliefs about market efficiency differ among investors and academics. Strong form believers agree with Fama, while weak form believers think active trading can generate profits. Value investors believe stocks can become undervalued. The existence of active traders is a counter-argument against an efficient market.
A real-world example of market efficiency is the impact of wider dissemination of financial information. The Sarbanes-Oxley Act of 2002 increased financial transparency, reducing equity market volatility.
Other examples of efficiency occur when market anomalies become widely known and subsequently disappear. For instance, the index effect anomaly, where a stock’s price would increase upon inclusion in an index, has largely disappeared due to increased information.
In conclusion, market efficiency is a complex concept with differing opinions. Understanding market efficiency is crucial for investors looking to make informed decisions.
