Market efficiency

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Market efficiency

• Kevin C.H. Chiang

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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.

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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.

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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?

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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?

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3 forms of market efficiency, III

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

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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.

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Implications, II

• In a semi-strong form efficient 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.

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Passive management

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

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Active management

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

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Alternative view The Challenge to Efficiency

• In the real world of investment, however, there
  are obvious arguments against the EMH. There are
  investors who have beaten the market - Warren
  Buffett, whose investment strategy focuses
  on undervalued stocks, made millions and set an
  example for numerous followers. There are
  portfolio managers that have better track records
  than others, and there are investment houses with
  more renowned research analysis than others. So
  how can performance be random when people are
  clearly profiting from and beating the market?
• Source Investopedia.com.

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So, what do you believe?

• Is the U.S. stock market efficient?
• Are international stock markets efficient?
• Are all markets, including the real estate market
  in Burlington, efficient?