Degrees of Market Efficiency
Profiting from the Efficient Markets’ Inefficiencies
It sounds like an oxymoron-profiting from the efficient markets' inefficiencies. But bear with us, there is reasoning behind it. Discussing it could actually be fun.
Modern economic theory claims that capital markets are generally efficient; but only to a certain degree, that is. There is also an assumption that a market could be perfectly efficient, when current prices reflect all publicly available information and when prices quickly adjust to the inflow of new information, thus maintaining an unbiased stance.
In a perfectly efficient market, investment risk is perfectly offset, since received prices are perfectly information-based. Of course, we all know that there is hardly anything perfect out there, capital markets included.
One of the fallacies of the perfectly efficient market is that if new information is immediately reflected in securities’ prices, then there is no need to analyze such information. If there is no need for analysis, then there is no need to search for new information. Finally, if new information is not analyzed, then it only makes sense that new information is not reflected in security pricing either. At the “end” of this vicious circle, it becomes clear that the perfect efficiency is not only lost, but it is lost completely.
Degrees of Market Efficiency
Hence, economic theory allows for various degrees or forms of market efficiency: weak, semistrong and strong form. Perhaps lessons about the strong form of efficient markets are the most illuminating. In the strong efficient market, all information about securities, be it public or private, is already reflected in the securities’ prices. Any new information that enters the market is expected to affect prices. However, since such information is randomly distributed, the securities’ prices also move at random, thus creating volatility.
Fallacies of the Strong Efficient Market
This is important to remember: the strong efficient market should not be equated with the perfectly efficient market. Why? Simply, the strong efficient market is very much riddled with interesting fallacies. One such fallacy is derived from studying mountains of trading data, confirming that on statistically significant level, company insiders and specialists have consistently outperformed the overall market.
This is because these professionals are often in possession of non-public, material information. Now, they do not have to engage necessarily in illegal insider trading to deliver better performance. Mere knowledge of companies and markets’ inner-workings is often sufficient for them to gain the upper hand. Yet, such sequence of events is in direct violation of the strong efficient market theory; hence the fallacy.
Research analysts, on the other hand, on average deliver “hit-and-miss” results. They have considerable theoretical and analytical skills at their disposal, but they also have only public material information to work from (or at least they should have only such information). What is missing from the mix is inside and/or specialized knowledge. And finally, the only group confirming the strong efficient market hypothesis includes professional money managers, who generally offer inconsistent performances relative to markets or benchmarks.
What Is in It for You?
What should this rather short review of the efficient market theory mean to readers such as you? Well, the bottom line is that if you can find superior analysts and money managers whose opinions can be obtained at relatively reasonable price (not an easy feat, you’ll soon see), stick with them! In other words, you don’t have to navigate financial markets’ mazes alone. Expertise and experience of superior analysts and money managers is likely to help you make loads of money in securities markets.
(Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005)
