Market efficiency

Kevin C.H. Chiang

Efficient market

(Informationally) efficient market: a market in which security prices adjust fully and rapidly to the arrival of new information and, therefore, the current prices of securities fully reflect all available information about the security.

3 sufficient conditions for an efficient market (Fama)

A large number of competing profit-maximizing participants analyze and value securities, each “independent” of the others.

New information comes in a “random” fashion.

The competing investors attempt to adjust security prices rapidly to reflect the effect of new information.

3 forms of market efficiency, I

Weak form: prices reflect all information contained in the history of past trading. Question: do past returns and prices predict future returns?

3 forms of market efficiency, II

Semi-strong form: prices reflect all publicly available information (earnings, dividends, PE ratios, book-to-market ratios, political news, etc.) Question: how quickly do prices reflect all public information?

3 forms of market efficiency, III

Strong form: prices reflect all relevant information, including inside information. Question: Do insiders make abnormal returns?

Testing

Does a known strategy produce consistently abnormal returns after adjusting for investment risk and transaction costs?

No: the market is quite efficient. Yes: evidence against the EMH.

Implications, I

In an efficient market, technical analysis is useless.

In a semi-strong form efficient market, fundamental analysts (country analysts, industry analysts, and company analysts), on average, will not outperform the market.

Implications, II

In a semi-strong form efficient market, fundamental analysis is useless.

In this market, a portfolio manager should: (1) determine a proper level of risk tolerance, (2) form a portfolio consisting of the risk-free asset and a well-diversified risky portfolio (passive management), and (3) minimize taxes and total transaction costs.

Passive management

No attempt to find undervalued securities. No attempt to time. Hold a well-diversified portfolio.

Active management/selection

Believe that one can beat the market. Find undervalued securities. Time the market.