Market efficiency as a concept, is quite important in financial analysis. The efficiency is a term that is commonly used to imply a market that is characterized by relevant information based on the prices of financial assets. Occasionally, economists use the term efficiency when referring to the way in which various resources of production are employed to improve the market’s operation (Palan 2007, p. 33).
Investors can only achieve large profits from their investment plans if and only if the capital markets compete sufficiently. This is a practice that is normally carried out in simple microeconomics. The concepts of the capital markets are currently accepted by majority after making no sense in the past decades. As a matter of fact, the empirical studies of security markets were very few up to mid 20th century (Palan 2007, p. 41).
The anticipation of the concepts of market efficiency was done by some economist scholars in the beginning of the 20th century. According to the economists, past, present and future trends help to determine the price in the market. However, the trends do not reflect clearly when it comes to price changes (Harder 2010, p. 5). The informational efficiency can be evaluated mathematically even if its effects do not predict these price’s fluctuations. This concept has given rise to the various analytical results of the current financial concepts (Harder 2010, p. 5).
There has been emergence of theories of speculative markets together with empirical observations that are yet to be approved by economic practitioners. Some of these theories articulate that market prices are normally subjected to random fluctuations as witnessed in the United States stock prices (Pompian 2006, p. 23).
There have been difficulties in citing out the causes of price fluctuations in the equity markets. Some studies have revealed that there is no certainty in the predictability of the market performance. The studies have shade light to concepts, different forms of market efficiency and the importance of efficiency in the market (Pompian 2006, p. 29).
The main purpose of investing money in a stock exchange market is to generate a return on the money invested. Not only do majority of these investors try to make a profitable return but also to outperform the market itself (Palan 2007, p. 39). As depicted in the efficient market hypothesis in 1970, market efficiency suggests that prices should fully reflect the available information in a given market at any time. As a result, investors do not have the advantage of speculating a return on prices of stock since no investor has access to the information (Moyer, McGuigan, and Kretlow 2007, p. 58).
The information does not only entail the financial issues and research, but other aspects as well. Some of these aspects include the information on social, politics and economic events. The perception of investors on these aspects would always be reflected on the prices of the stocks. In an efficient market, response of prices based only on the available information outperforms the participants since all the investors are accessible to the same information (Moyer, McGuigan, and Kretlow 2007, p. 66).
Not every market is likely to be efficient to every potential investor. Some specific markets such as the New York Stock Exchange are considered efficient markets in relation to the average investor. In other words, there is great possibility that a market may be efficient to a specific group of investors and fail to be efficient to other investors. This is as a result of differential tax evaluations and costs of making transactions (Palan 2007, p. 44).
Market efficiency may also be influenced by assumptions made on the availability of information to the investors which in turn may be reflected on the price. Assumptions that all information is born on the market prices would imply that only the investors that have access to outside information will be likely to outperform the market (Palan 2007, p. 37).
Price of Stocks in Efficient Market
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In an efficient market, the true value of the investment is estimated by the prevailing price in the market since it is considered unbiased estimate. In this kind of market, the price does not have to be equal to true value of the investment at every time. For instance, the prices can surpass or be less than true value provided these fluctuations are random in nature. The key requirementin an efficient market is that the price anomalies remain unbiased (Shefrin 2008, p. 5).
A fluctuation of the market price from the true value has an economic implication. The fluctuation implies that there could be an equivalent possibility of overvaluation or undervaluation of stocks at that particular time (Shefrin 2008, p. 5). It is also a fact that this deviation is not linked to any predictable variations. In market efficiency, for example, stocks with very low PE index should not be undervalued as compared to the stocks with higher index. Therefore, the price deviations in an efficient market should not result in under or overvalued stocks in spite of the kind of investment strategy employed (Shefrin 2008, p. 6).
Market efficiency does not overrule the possible anomalies that may result in the production of huge profits. The efficiency does not mitigate prices to be equivalent to correct value every time. Prices may be randomly over or determined but with time would correct themselves to the mean value (Shefrin 2008, p. 7). Therefore, there can’t be consistent investment plans that outperform the market. In fact, the efficiency assets that any outperformance of the market occurs as a result of chance but not skills (Shefrin 2008, p. 7). A typical example of a market that would be perceived to be efficient is New York Stock Exchange (NYSE).
Transforming a Market to the State of Efficiency
Before the transformation, a market is required to be liquid and averagely large. The accessibility to information should be guaranteed to enable investors determine the costs of transaction (Palan 2007, p. 21). The costs of transactions should also be made cheaper as compared to the expected profits of the stocks. The investors in this market have to have money at every time to enable them outperform the market in cases of inefficiency (Palan 2007, p. 26).
For a market to attain efficiency, the potential investors must first regard the market as inefficient. The investors would then have the notion that the market is possible to outperform. The transformation of the market to this state is simple. It is the investment strategies geared at outperforming the market that help the market to achieve the efficiency state (Moyer, McGuigan and Kretlow 2007, p. 62).
Forms of Efficiency
It is quite challenging to attain the purest form of market efficiency. There are three classifications of the efficiency that are actually applicable to the most markets. The first form; strong efficiency is the strongest degree. In this form, both public and private information are considered while determining the price of a stock. No information would enable in investor to have an advantage over other investors (Harder 2010, p. 9).
Semi-strong efficiency is the second type of the practical forms. This form advocates for inclusion of public information in the process of calculating the prevailing share price of a stock. Fundamental and technical analysis could not be used to gain any advantage over others (Harder 2010, p. 9). The last form in which market efficiency can exist is termed as weak efficiency. In weak efficiency, past stock prices are some of the major factors that would be reflected in the present prices. In this case, technical analysis would not be used to outperform the market or to predict market trends (Harder 2010, p. 9).
Implications of Market Efficiency
An efficient market implies that there are no possibilities of outperforming the market and therefore, an investor would not receive returns that surpass the average profits as set by the market. For this implication to hold, it is required that the market has to attain the real efficiency state. This fact has led to the ever increasing number of investors. The investors have resolved to take risks since they are able to see the great chances of getting big returns (Palan 2007, p. 48).
Research and valuation of equity would be expensive and would not be of any benefits to the people concerned. Locating stocks which are undervalued should be random with benefits accrued from collecting information and equity research being able to cover the expenses incurred in conducting the research (Harder 2010, p. 10).
Random plans of diversifying various stocks or the market index would involve very little information expense. Any other strategy that form bulk information and execution costs would be surpassed by minimal execution costs (Harder 2010, p. 5). Portfolio managers as well as strategists of investments would not influence the value of the sttocks. Lastly, strategy of minimizing trading would be greater than strategy requiring frequent investments (Harder 2010, p. 5).
Anomalies associated with Market Efficiency
There are several arguments against the hypothesis of market efficiency. Some of these arguments actually hold. Investors such as Warren Buffett have managed to beat the market. Buffett’s investment strategies were exclusively based on undervalued stocks but ended up making superior gains in terms of millions (Harder 2010, p. 20).
The claim of random performance has been challenged in several occasions. For instance, there are various portfolio managers that have greater track records than others. Some investment houses also have better renowned research analysis than their fellow investment houses. In other words, hypothesis of random performance does not hold exclusively following the occurrence of these assorted cases in which investors are profiting and thereby outperforming the market (Harder 2010, p. 21).
It has also been proved that consistent performance occurs occasionally. It is a fact that greatly contradicts the efficient market hypothesis. For instance, a pattern of great returns is achievable in the first month of every year as depicted in the January effect (Harder 2010, p. 21). In blue Monday on Wall Street, weekend effect has led to fewer purchases on Friday afternoons as well as Monday mornings. There is consistency in prices shooting up on the previous day and after the weekend as compared to the rest of the days of the week (Harder 2010, p. 21).
The studies that have been conducted on behavioral finance to investigate the effects of investors’ psychology and variations in stock prices, confirm that predictable patterns exist in the market. More investments are made on undervalued stocks whereas the investors tend to release the overvalued stocks. It is only in market with many participants where this tendency results in efficiency (Harder 2010, p. 21).
In cases of short-terms shareholder trends, investors tend to majorly invest in latest and hottest stocks. As a result, the prices of the stocks are influenced rendering the market inefficient. Prices therefore do not reflect the market together with the available information. In fact, in this situation, prices are controlled by investors that are struggling to make profit (Harder 2010, p. 21).
Importance of Market efficiency
The concept of an efficient market is quite important especially to the investors. It enables the investors to make better investment decisions. By taking advantages of inefficiency, whenever it occurs in a market, the investors may enjoy above average profits through investing in various markets (Harder 2010, p. 10).
The concept of stock’s valuation also is important to the managers in the sense that it provides them with guidelines of managing the stock exchange markets in behalf of the stockholders. The establishment of discount rates of shareholders’ rates of return is done by the help of the markets’ benchmark rates such as the Risk Free Rate (Harder 2010, p. 12). Efficient market entails low costs of transactions and thereby enhancing trade stocks. It is in these markets that the prices are fairly and quickly reflected in the information available. Lastly, risks in an efficient market are efficiently determined since the market has adequate stocks (Harder 2010, p. 12).
There are some uncertainties regarding efficient market. Some economists feel that a market is prone to effects of different eventualities and therefore would not abide exclusively by the efficient market hypothesis. In fact, some surprising changes in the market normally result in inefficiency of the market.
In practice, the markets can never achieve absolute efficiency of become. In most cases, the markets are composed by both efficiency and inefficiency states. Daily decisions that investors make do not reflect immediately into the market prices. As a matter of fact, if there had been absolute efficiency, no investor would be seeking above average profits. This quest to make greater profits is the main object behind fluctuation of market efficiency
It could be claimed that more markets are becoming efficient nowadays as a result of the rise internet applications. The internet plays a big role in ensuring that necessary information is made available to every potential investor in time. It is predicted that as technology advances, the markets will become more efficient.