Market Efficiency
Introduction
Market efficiency is used to refer to the extent to which stock prices and other securities are reflecting all the available information in the market. This concept was developed in 1970 by Eugene Fama, an economist. Fama also coined the theory of efficient market hypothesis, which states that it is not possible for an investor to outperform the market. This is because all the available information regarding the market is already built into all stock prices (Heakal par. 3). Many investors concur with this theory, as they are the ones that buy index funds that track the overall market performance. They are also promoters of the passive approach to portfolio management. Market efficiency can be described as the degree to which the market is furnished with information that assists in maximizing the opportunities for both the sellers and buyers of securities. It also helps to ensure that the transactions in the maximized opportunities are effected without increasing the transaction costs.
Levels of Market Efficiency
When describing the actual efficiency of the market, academics and investors tend to have different viewpoints. The different viewpoints have resulted in three levels of efficiency: strong, semi-strong, and weak. The investors and academics that believe that the market is strong adhere to the views of Fama. They are also referred to as passive investors (Speidell 22). There are traders who believe that active trading of securities can result in abnormal profits for the investor. These are the ones that have adopted the weak version of market efficiency. The semi-strong believers of the efficient market hypothesis have no solid leaning; they can at times fall on the strong side or weak side of the hypothesis, depending on the prevailing circumstances.
The weak believers of the efficient market hypothesis often deduce that stocks can become undervalued or priced below what they are actually worth. They invest in the stocks they feel are undervalued and dispose of them when the price goes up earning profits in the process. As a result, these types of investors are referred to as the value investors (Heakal par. 4). The logic used by persons that do not believe in an efficient market is that active traders exist in the securities market. Their assertion is that there is no point in becoming an active trader or hiring an active manager at a fee if there is no opportunity to reap abnormal profits from the market. This is because efficient market hypothesis assumes that efficient markets should have low transaction costs.
Consequences of Market Efficiency
An interesting effect of market efficiency is that that the prices of the stocks in an efficient market become random as opposed to predictable. Information found in the market is not only from the financial news and reports, but also includes economic, social, and political information. This information, whether true or otherwise, is reflected in the price of stocks (Heakal par. 7). Efficient market hypothesis stresses that the information is only able to affect and determine the prices of stocks in the market only if it is made available to all the players in the market. As all the players in the market tend to have access to this information, it is thus hard for any of them to use it to gain advantage over the others. The prices of securities in the stock market are random and unpredictable, which makes it difficult to notice an investment pattern. This makes it impossible to succeed in having a planned approach to investment.
This unpredictability of the stock prices is referred to as the “random walk” of prices, and it is described by the efficient market hypothesis as the cause of the failure to have an investment strategy that can beat the market consistently. Efficient market hypothesis discourages the investors from hiring portfolio managers and recommends that they invest in an index fund to avoid incurring transaction costs. Another consequence of market efficiency has been the increase in investors that have opted to invest in exchange traded funds that are passively managed (Jarrow and Martin 8). These ETFs that are managed passively constitute to about a third of the equity in the United States. These ETFs offer better tax efficiencies compared to the traditional mutual funds. The ETFs were originally designed as a better way for long-term hold and buy investors, but it has had the unintended consequence of being traded intensively as an investment vehicle. ETFs have had a negative effect on the informational efficiency of the stock market. The trading costs have gone up, and the stock prices have become more correlated than before (Speidell 23). As a result, the investors can no longer control risks through diversification, unlike in the past.
Efficient market hypothesis has rendered both technical and fundamental analysis techniques in making of investment decisions useless. This because technical analysis is dependent on past experiences and results, and as per the hypothesis of market efficiency, past results cannot be used to gain an advantage over the market. In the case of fundamental analysis, the assertion of efficient market hypothesis is that the determination of the price of securities takes into account all of the information that is publicly available (Tavor 95). This makes it impossible to gain abnormal returns from the stock market using this information, rendering fundamental analysis useless as a result. Efficient market hypothesis has also impacted the portfolio management processes. The investment policy statement that is made at the beginning of a portfolio management process lists the objectives and constraints of the investor. If the investor is a believer of the market efficiency hypothesis, then the focus of the management of the portfolio is shifted from focusing on achievement of above average returns. Rather, it becomes focused on passive investment (Tavor 97). The portfolio manager, therefore, focuses on the risks having assumed that above average returns are not achievable. The portfolio manager is expected to outperform all the other traders in the market by making calculated risks. The efficient market hypothesis implies that this goal is not achievable, defeating the purpose of having a portfolio manager in the first place.
A general assumption of the efficient market hypothesis is that there is no way that an investor can make above average returns in the securities market. Therefore, the market rate of return is the one expected for all investors under this notion. It is wise for the investor to endeavor in minimizing the costs that are incurred in the process of investing (Tavor 99). The achievement of a market rate of return requires that the investor diversify in various amounts of stocks. This is not possible for a small investor. The average investor is left with an index fund as the best option for investment. This index fund is a cost effective way of earning profits in the securities market.
A Case Against Market Efficiency
In practice, the efficient market hypothesis faces a lot of opposition. For instance, some investors perform exemplarily in the market and have thus been given significant prominence, such as Warren Buffet. The investment strategy by Warren Buffet focuses on undervalued stocks which has earned him billions of dollars. This has set precedence for many of his followers in matters of investment. There are also some portfolio managers that are better performers than others in the management of investments. There are also investment houses that have a history of performing research analysis that has resulted in above average returns for their clients (Jarrow and Martin 15). This raises the question of how performance can be random when there are people who are performing exceedingly well in the market thus realizing outstanding profits. Other counterarguments against market efficiency include the fact that some consistent patterns are apparent in the financial markets. For instance there is a January effects named after the tendency of the first month of the year posting the highest profits, and the weekend effect of having higher earnings immediately before Friday.
Conclusion
In conclusion, market efficiency favors the concept of the random performance of the securities market, and in a way, discourages active investors with the notion that there is no way of outperforming others the market. However, another group of active investors reject the hypothesis of market efficiency. Instead, they risk their investment in stocks that they consider to be undervalued. Given that both arguments tend to make the expected gains, this is an affirmation of the irrational nature of investors.
Works Cited
Heakal, Reem. “What Is Market Efficiency?.” Investopedia, 2017. http://www.investopedia.com/articles/02/101502.asp.
Jarrow, Robert A., and Martin Larsson. “THE MEANING OF MARKET EFFICIENCY.” Mathematical Finance, vol 22, no. 1, 2012, pp. 1-30. Wiley-Blackwell.
Speidell, Larry. “Frontier Market Investing: Active Versus Passive.” The Journal Of Investing, vol 25, no. 4, 2016, pp. 20-26. Institutional Investor Journals.
Tavor, Tchai. “Target Price Rumor And Its Effect On Market Efficiency.” The Journal Of Investing, vol 22, no. 4, 2013, pp. 93-102. Institutional Investor Journals.