EFFICIENT FINANCIAL MARKETS
An efficient financial market exists when security prices reflect all available public information about the economy, about financial markets, and about the specific company involved. The implication is that market prices of individual securities adjust very rapidly to new information. As a result, security prices are said to fluctuate randomly about their â€œintrinsicâ€? values. The driving force behind market efficiency is self-interest, as investors seek under-and overvalued securities either to buy or to sell. The more market participants and the more rapid the release of information, the more efficient a market should be.
New information can result in a change in the intrinsic value of a security, but subsequent security price movements will not follow any predictable pattern, so that one cannot use past security prices to predict future prices in such a way as to profit on average. Moreover, close attention to news releases will be for naught by the time you are able to take action, security price adjustments already will have occurred, according to the efficient market notion. Unless they are lucky, investors will on average earn a â€œnormalâ€? or â€œexpectedâ€? rate of return given the level of risk assumed.
Three Forms of Market Efficiency
Eugene Fama, a pioneer in efficient markets research, has described three levels to market efficiency:
Ã˜ Weak-form efficiency: current prices fully reflect the historical sequence of prices. In short, knowing past price patterns will not help you improve your forecast of future prices.
Ã˜ Semi-strong-form efficiency: current prices fully reflect all publically available information, including such things as annual reports and news items.
Ã˜ Strong-form efficiency: current prices fully reflect all information, both public and private(i.e. information known only to insiders)
The markets for common stocks, particularly listed New York Stock Exchange is reasonably efficient. Security prices appear to be a good reflection of available information, and market prices adjust quickly to new information. About the only way one can consistently profit is to have insider information, that is, information about a company known to officers and directors but not to the public. And, even here, Security regulations act to limit attempts by insiders to profit unduly from information not generally available to the public. If security prices impound all available public information they tell us a good deal about the future. In efficient markets, one can hope to do no better.
Stock market efficiency presents us with a curious paradox: The hypothesis that stocks markets are efficient will be true only if a sufficiently large number of investors disbelieve its efficiency and behave accordingly. In other words, the theory requires that there be a sufficiently large number of market participants who, in their attempts to earn profits, promptly receive and analyze all information that is publicly available concerning companies whose securities they follow. Should this considerable effort devoted to data accumulation and evaluation cease, financial markets would become markedly less efficient.
Does Market Efficiency Always Hold?
We know that stock market levels tend to increase overtime in relatively small increments, but when they decline it is often with a vengeance.. A number of explanations have been offered for any crash but none is particularly compelling. In the opinion of investors.
We are left with uneasy feeling that although market efficiency is a good explainer of market behavior most of the time and securities seem to be efficiently priced relative to each other, there are exceptions. These exceptions call into question market prices embodying all available information and, therefore whether they can be completely trusted.. Perhaps these anomalies in explanation in a crash of stock market seem to be the result of an inadequate measurement of risk. But perhaps they are due to things that we really do not understand. Although the concept of financial market efficiency underlies a good deal of our thinking, we must be mindful of the evidence that suggests exceptions.