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What is the role of efficient markets in finance?

What is the role of efficient markets in finance?
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Have you heard of the terms efficient market hypothesis and informationally efficient markets? You cannot fully understand finance without understanding the role that efficient markets play.

As an investor, trader, or business person, it would be advantageous for you to gain knowledge about these particular concepts as they are becoming more and more relevant in the world of finance. In this article, we take a look at the efficient market hypothesis and what role efficient markets play.

What is market efficiency and efficient markets?

Market efficiency is a rather broad term that is used to describe information metrics within a particular market. An efficient market would be one in which all information is completely and accurately transmitted and incorporated.

Understanding informationally efficient markets

The efficient market hypothesis (EMH) states that financial markets move unpredictably because they are informationally efficient.

What does informationally efficient mean? When discussing finance and the stock market, informationally efficient means that all of the information of a stock has been incorporated into its price. Let’s look at it like this…traditionally, when new information or speculation came out about a certain stock, investors and traders would begin to research and this would cause changes in the price of the stock. However, in an informationally efficient market, following press releases etc, there would be little to no price change as this info would already be incorporated into the price of the stock.

An informationally efficient market is a lot more than simply a market that operates efficiently, and the two should not be confused. Just because certain market operators ensure that everything runs smoothly and that orders are filled properly does not mean that stock prices are updated according to the latest information.

What is the efficient market hypothesis (EMH)?

We have already briefly mentioned EMH, but it’s important to understand the concept of EMH in full.

The efficient market hypothesis asserts that all informationally efficient stock sits at its fair, true price. This makes it virtually impossible for investors to purchase overlooked, undervalued shares, or to sell shares for more than it’s worth. There is no more outwitting the market or using brand new information to your advantage (as it would have already been incorporated). Because of this, EMH also states that the market moves randomly, in an untrending manner, making it near impossible for investors to predict the markets’ movements.

There are three levels of the hypothesis, including:

  • Weak- This form of EMH asserts that data volumes and price movements do not affect the overall price of the stock. By making use of fundamental analysis tactics, investors can still find undervalued stocks as well as overvalued stocks, and there is still profit to be made by making use of financial statements. In the case of technical analysis, weak-form EMH deems this to be invalid.
  • Semi-strong- The main characteristic of the semi-strong EMH is that it states that the market displays and incorporates all current public knowledge into its prices. All public knowledge is quickly, almost instantly absorbed into the market, making fundamental analysis essentially useless to investors. The only information that will help investors outperform the market is by making use of information that is not yet readily available to the public.
  • Strong- Strong-form EMH suggests that the market has already incorporated all current information, both public and private and that no amount of research into stock will give an investor any stronger foothold than the average investor. No investors are able to earn excess returns. In order for a market to be strong-form efficient, there needs to be where investors are consistently unable to earn excess returns.

What we can take away from the above is that a truly efficient market eliminates the possibility of ‘beating the market’. As the quality, amount, and availability of information increases, the more efficient a market should become.

Brief background on efficient markets

The term ‘market efficiency’ has been taken from an economic paper written by Eugene Fama in 1970, but Fama himself recognises that the term is quite misleading as no one can clearly define what market efficiency truly is. Despite the limitations of the term, it is used frequently in the world of finance and economics. Fama is also responsible for creating the efficient market hypothesis, which has been met with both applause and critique. But no matter whether you agree or disagree with the hypothesis, it should be noted that Fama was awarded a Nobel Prize for his efforts in economics.

Those who agree with Fama’s findings tend to invest solely in index funds as they feel that this is the safest way to play an efficient market.

Those who disagree have scrutinised Fama’s work immensely and have been able to come up with gaps and flaws in the concept. One of the biggest counter arguments is that active traders still exist, and if markets were truly efficient, there would be no incentive of becoming active traders.

Whether you agree or disagree with the hypothesis, having knowledge about it can only assist you in becoming a better investor/ trader.

Are there any ways to decrease market efficiency?

Decreasing market efficiency is attractive to many investors as it gives them an opportunity to make excess returns off of the market and create greater profitability for themselves. One of the only ways in which market efficiency can be decreased, thus creating more opportunities to access undervalued and overvalued shares, is through private information. If an investor had to gain access to private information that has not yet been incorporated into the market, they could be a step ahead of many other investors.

The use, secrecy, and sale of private information can lead to a number of issues, but gaining access to private information is seen as one of the only ways for investors to have a chance at making exceptional trades.

Interested in investing and trading? Remember to start with basics and never to invest more than you can afford to lose.

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