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Market efficiency is one of the most controversial topics in finance. On one side of the debate are most academics and on the other side are many practitioners whose wealth depends on investors trading. (Some say we need to get out more!)
The debate has gone full circle: from the market can not be efficient to “well it is efficient, but there are some chinks in the armor of efficiency.” Market efficiency is the idea that the market price is right. Thus efficiency comes about as the result of competition. The many participants are all trying to be the first to get information that will effect security prices. By trading on this information, the price will quickly reflect the information. For example, suppose you find out some good news about a firm. You go and buy the stock. This action drives the price up. If it gets too high you will sell. This will keep the price at its correct level.
Information and competition are the underlying principles guiding market efficiency. Think of an asset price being based off of forecasts of future conditions. (example: the future supply, demand, competition, etc.) These forecasts are made using the information available in what financial economists call information sets. The larger the information set, the more accurate the forecasted price (information is power).
Traditionally, these information sets have been classified into three categories: 1) past asset price data, 2) information that is probably available, and 3) private information. If all past information is incorporated in the price then it should be impossible to consistently beat the market using technical analysis and the like. Most studies have found this to be the case although a recent study by Lo, Mamaysky, and Wang (JF 2000) has casted some doubt on this.
Further, the continued existence of technicians is troubling. However, the gains to be had using these methods are small most believe that this past information is “in the price” and that technical analysis does not work. If this is the case, the market is called weak-form efficient. It means that you can not make money on a consistent basis using past information. Tests for weak-form efficiency include looking for patterns and other statistical tests such as the runs-tests and filter rules. If we expand the “information set” to include not only past information but also information that is publicly available, then the market price is “more correct.” If this is the case any attempt to “beat the market” using publicly available sources (such as financial statements, news reports, magazine stories, and the like) will likely result in no extra abnormal return.
The ways that this is tested are with event studies and by looking at investors to see how many are consistently beating the market. Most event studies and the empirical findings that few investors do “beat the market” are consistent with this form of efficiency which is called semi-strong form efficiency.
The final form of efficiency is strong form efficiency. This says that all information (both public and private) is incorporated into the stock price. This is obviously false since people trading with inside information do beat the market.
One common error is to prescribe perfection to the markets. Markets
are amazingly good but not perfect. If markets are efficient it does not
mean you will not make money. It only means that you will not earn more
than you should earn for assuming that level of risk. Thus to say beating
the market means earning a return above and beyond the required return
for that level of risk. What chinks exist? As we already have mentioned--
programs on technical analysis. Farther though we have a tough time with
“bubbles.” If the market price is the correct price, how can we explain
the bubble in the Japanese market in the late 1980’s or even the Internet
bubble in 1998-99. In these incidences the high valuations were the result
of overly optimistic expectations. However, these anomalies are not enough
to throw out the preponderance of evidence that markets are extremely difficult
to beat and that our efforts are generally better spent elsewhere. To be
continued next week: reasons for the “chinks in the armor”. for more on
market efficiency: http://www.financeprofessor.com/summaries/Ball1994marketefficiency.htm
http://www.financeprofessor.com/summaries/fama91efficientcapitalmarketsii.htmhttp://www.financeprofessor.com/introcorpfinnotes/WhatisEMH.html
The
Lo, Mamaysky, Wang article can be found at http://www.afajof.org/asp/abstract.asp?aid=265&iid=4&vid=55&id=60686168647374759399919514314414514614714814
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Permission granted for in class use.