[Corporate Finance] Foundation of Finance Topics (10): Market efficiency

Market efficiency refers to the extent to which stock prices reflect all available, relevant information. The Efficient Market Hypothesis (EMH) suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. In an efficient market, securities are always traded at their fair value, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices consistently.

Forms of Market Efficiency

Market efficiency is often discussed in the context of three forms, as proposed by economist Eugene Fama:

• Weak Form Efficiency:
  
  • Definition: In weak form efficiency, all past trading information is already reflected in stock prices. Thus, technical analysis (based on past market data) cannot consistently yield excess returns.
  • Implication: Investors cannot predict future stock prices based on past price trends or patterns.
• Semi-Strong Form Efficiency:
  
  • Definition: This form asserts that all publicly available information is reflected in stock prices, not just past trading data. This includes financial statements, news, economic factors, etc.
  • Implication: Fundamental analysis (based on public information) cannot consistently achieve abnormal returns.
• Strong Form Efficiency:
  
  • Definition: In strong form efficiency, stock prices reflect all information, public and private (insider information).
  • Implication: No one can consistently achieve excess returns, even with inside information.

Researchers test for market efficiency by looking at how quickly and accurately prices respond to new information. If markets are efficient, new information should be quickly reflected in stock prices.

Market Efficiency and Investment Strategies

• Passive vs. Active Management: In efficient markets, active investment strategies (attempting to outperform the market) are less likely to succeed than passive strategies (like index funds), which simply aim to match market returns.
• Behavioral Finance: Market efficiency is often challenged by behavioral finance, which suggests that psychological factors and irrational behavior can lead to mispriced securities.
• Investor Expectations: In efficient markets, investors should expect to earn a return that is commensurate with the risk of their investment, without consistently beating the market average.
• Role of Information: Efficient markets rely heavily on the free flow and wide availability of information. Any barriers to information access can impact market efficiency.

Understanding market efficiency is crucial for grasping how financial markets operate and the limitations of different investment strategies. While the Efficient Market Hypothesis suggests that achieving returns significantly higher than the market average is unlikely, especially over the long term, debates continue regarding the extent to which real-world markets exhibit efficiency.