3. Investment Planning. 12. Efficient Market Theory Flashcards
Information may be one of the most valuable commodities in the world of business. If you were to know something that will impact a company’s earnings before anyone else finds out about it, you will likely be able to take advantage of that knowledge. But how long will you be able to maintain the advantage of being the first to know? What will happen when everyone else finds out? Is it even possible for you to come across valuable information and legally act upon it before everyone else? In an efficient market, information is quickly and widely disseminated, thereby allowing each security’s price to adjust rapidly in an unbiased manner to new information so that it reflects the investment’s value.
The Efficient Market Theory (EMT) module, which should take approximately two and a half hours to complete, will present the market efficient model and the results of studies and observations of an efficient market.
Upon completion of this module you should be able to:
* Describe the efficient market model,
* Enumerate the levels of market efficiency,
* State the observations made about efficient markets,
* Explain the methods of testing efficient markets, and
* Identify the anomalies that exist in efficient markets.
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What makes efficient market theory an interesting paradox?
- The efficient market theory is one of the most interesting paradoxes in the investing world
- In an efficient market, the price of any security will reflect all past and present information available
- If this is true, there would be no reason for anyone to seek returns above the market
- Studies have shown the US markets to be highly efficient
- Since few mutual funds have outperform the markets, it is safe to say that investors of index mutual funds subscribe to this theory
- But millions still are spent by active managers on fundamental and technical analysis
- Their efforts make it possible for the markets to be efficient
- Security analysts spend their time uncovering all available information on a security and then act accordingly. If they don’t do the analysis, then market price will not represent all information available and will be less than perfectly efficient
- In seeking to disprove the market is efficient, they actually make it more efficient
- This module with discuss the various forms of market efficiency and present test result of the US market
Section 1 – Market Efficiency
A reasonable goal of government policy is to encourage the establishment of allocationally efficient markets, in which the firms with the most promising investment opportunities have access to the needed funds. However, in order for markets to be allocationally efficient, they need to be both internally and externally efficient. In an externally efficient market, information is quickly and widely disseminated, thereby allowing each security’s price to adjust rapidly in an unbiased manner to new information so that it reflects investment value. An internally efficient market is one in which brokers and dealers compete fairly so that the cost of transacting is low and the speed of transacting is high.
Pricing inefficiencies interest investors because a discrepancy between the price and the value of a security provides a profit opportunity. Investment opportunities involving individual securities or entire markets can be categorized into three levels of pricing efficiency. These categories are based on the amount of information that the investors in the market use in their valuations. The markets are categorized into weak form efficient, semi-strong form efficient, and perfectly or strong form efficient markets.
To ensure that you have a solid understanding of market efficient model, the following topics will be covered in this lesson:
* Efficient Market Model
* Weak Form Hypothesis
* Semi-Strong Form Hypothesis
* Perfectly Efficient Hypothesis
Upon completion of this lesson, you should be able to:
* Differentiate between the levels of market efficiency,
* Explain the efficient market model,
* State Fama’s formulation of the efficient market model, and
* Describe how random walk applies to pricing efficiency.
In a perfectly efficient market, which of the following investment choices is the most logical for someone looking to invest in the stock market?
* Stock Index Funds
* Contrarian Stock Funds
* Momentum Stock Funds
* Growth Stocks
* Value Stocks
Stock Index Funds
* In a perfectly efficient market, there is no opportunity to gain abnormal returns beyond the market. Therefore, a stock index fund would produce the most returns possible.
Describe Market Efficient Price
If the price of a security reflects everything that is knowable about the security, we call it a perfectly efficient price. A perfectly efficient price is always equal to the security’s value, even though the value may change continuously to reflect the random arrival of new information. In other words, the price and value react in unison to the frequent appearance of news. Smart financial analysts who are active traders will not be able to enrich themselves in a perfectly efficient market because all the securities are priced correctly.
Some people are surprised to learn that prices should fluctuate randomly; they think that security prices should move smoothly through time. Prices should not move smoothly, because prices adjust rapidly as the information becomes available. These rapid price adjustments cause not smooth continuity, but randomness in the successive price changes of a security. Randomness means that a trend-like series of small upward (or small downward) price moves occurs rarely, if at all. If the price is going to change, it should change all at once, rather than in a series of small gradual adjustments. Sudden large price moves are desirable, so long as price movements in the opposite direction do not consistently follow them. Large quick price movement is a good sign that the market is not suffering from any learning lags.
PRACTITIONER ADVICE
As you recall, there are many variables used to calculate a security’s price, such as interest rates, earnings, discount rates, and growth rates. Most of these variables are based on assumptions, leaving room for error. For example, earnings are sometimes quoted based on the trailing four quarters. Others multiply the last quarter’s earnings by four. One method assumes that the past year’s earnings are indicative of the value of a company. The other assumes that the past quarter’s earnings are indicative of the future earnings potential of a company. Neither method is exact. When many analysts are looking at the same company, they will exhaust all probabilities, factors, and assumptions. Therefore, even though the value may not be exact from one analyst, the consensus of all the analysts can come close to the efficient price.
Section 1 – Market Efficiency Summary
In an efficient market a security’s market price will fully reflect all available information relevant to the security’s value at that time. A security’s investment value is the present value of the security’s future prospects, as estimated by well-informed and capable analysts, and can be thought of as the security’s fair or intrinsic value. The debate has gone on for decades as to the degree of market efficiency. Those who believe in passive management and index investing will say that the market is perfectly efficient. Fundamental analysts believe there are inefficiencies that can be turned into abnormal returns.
In this lesson, we have covered the following:
* Efficient Market Model states that the value of a security is a reflection of the information available about it. There are three forms: Weak Form, in which a security’s price reflects historical data; Semi-strong Form, in which a security’s price reflects historical and current public information; and Strong Form, in which a security’s price reflects all information (past, present, public and insider).
- Sources for Market Information: Information for weak form is much more readily available than the strong form. In a strong form market efficiency, hard to come by insider information will be readily used.
- Market Efficient Price: A perfectly efficient price would react immediately to new information and adjust to the new price. Less efficient prices will react differently; some will overreact, while others may lag.
- The Fama’s Formula of the efficient market model is a notation describing how investors generate price expectation for securities. The equation states that expected price for a security at the end of a period is based on the security’s expected normal rate of return during that period, which is determined by the information set available at the start of the period. Abnormal profits could not be earned if all information was available.
- Random Walk: Information arrives randomly in an efficient market. Investors incorporate new information immediately and fully in security prices. Consequently, security price changes are random.
What is the level of market efficiency, in which only previous security prices and volume data are reflected in current security prices, called?
* A strong form efficient market
* A semi-strong form efficient market
* A weak form efficient market
* A perfectly efficient market
A weak form efficient market
* A weak form efficient market exists when the market prices reflect only previous or historical information.
* In a semi-strong efficient market, the market prices reflect all public information.
* A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information.
What types of information do perfectly efficient prices reflect? (Select all that apply)
* Historical information
* Public information
* Inside information of the company
* Additional information that is more difficult to obtain
Historical information
Public information
Inside information of the company
Additional information that is more difficult to obtain
* A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information. Knowable information also includes inside information of the company. However, this must be used only in a legally approved manner.
When a series of prices represents a situation in which changes in the value of the prices are independent and identically distributed, we refer to the series as a random walk.
* False
* True
True
* The random walk model is a situation in which changes in the value of a random variable are independent and identically distributed.
* When applied to common stocks, it refers to a situation in which security price changes are independent and identically distributed. This means that the size of a security’s price change, from one period to the next, can be viewed as being determined by the spin of a roulette wheel.
Which of the following statements does not apply to an efficient market? (Select all that apply)
* Investors generate price expectations for securities.
* Under or overvaluation of securities can be expected.
* Abnormal profits can be made by using a set of information to formulate buying and selling decisions.
* Investors must make full and accurate use of the available information set.
Under or overvaluation of securities can be expected.
Abnormal profits can be made by using a set of information to formulate buying and selling decisions.
Investors must make full and accurate use of the available information set.
* In an efficient market it is impossible to make abnormal profits by using a particular set of information to formulate buying and selling decisions. That is, investors should expect to make only normal profits by earning a normal rate of return on their investments. An efficient market is defined as one in which every security’s price equals its investment value at all times. In an efficient market, a set of information is fully and immediately reflected in market prices.
Section 2 – Observations
The investment world is populated by aggressive, well-educated, and hard-working individuals. Their objective is to identify mispriced securities and profit by appropriately buying and selling such securities. It seems improbable that these investors would frequently permit abnormal profit opportunities to go unexploited for very long. Ironically, it is the combined actions of these investors that make the attainment of their goal so difficult.
Observations about perfectly efficient markets and transaction costs are largely related to the expected rate of return on investments. They also reveal interesting aspects regarding characteristics of investors and the strategies they use.
To ensure that you have a solid understanding of observations, the following topics will be covered in this lesson:
* Observations about Perfectly Efficient Markets
* Observations about Perfectly Efficient Markets with Transaction Costs
Upon completion of this lesson, you should be able to:
* List the observations regarding perfectly efficient markets,
* Describe the result of investors believing that markets are not efficient,
* Explain why publicly known strategies cannot generate abnormal returns,
* State why an investor’s impressive past performance is not an indicator of future performance, and
* Describe the two important observations about transaction costs.
Describe No Professional Advantage
Observation 5: Professional investors should fare no better in picking securities than ordinary investors.
Prices always reflect investment value, and hence the search for mispriced securities is futile. Consequently, professional investors do not have an edge over ordinary investors when it comes to identifying mispriced securities and generating abnormally high returns.
PRACTITIONER ADVICE:
If the market were not efficient, experienced managers would consistently perform better than their benchmark index. Since there are very few managers who beat the market, and fewer who can consistently beat the market, it would seem that the market is fairly efficient. However, sub-sectors of the market, such as international and small cap markets, are less efficient. In those markets, experienced managers can take advantage of hidden value. Those who outperform the market often create value in what they are investing. For example, when Warren Buffet purchased Jordan’s Furniture in the Northeast, he was able to immediately improve profits for the company because of the furniture distribution companies he owned.
Describe the Passive Investing Advantage
Observation 2: Investors will do just as well using a passive investment strategy where they simply buy the securities in a particular index and hold onto that investment.
Such a strategy will minimize transaction costs. It can be expected to do as well as any professionally managed portfolio that actively seeks out mispriced securities and incurs costs in doing so. Such a strategy can be expected to actually outperform any professionally managed portfolio that incurs unnecessary transaction costs (by, for example, trading too often).
Note that the gross returns of professionally managed portfolios will exceed those of passively managed portfolios having similar investment objectives. At the same time, the two kinds of portfolios can be expected to have similar net returns.
PRACTITIONER ADVICE:
If markets were truly efficient, then it would be difficult to outperform indexes over the long term. Expenses and taxes would become important variables. Passive investment has the advantage of low expenses and tax efficiency.
Section 2 – Observations Summary
The observations made in a perfectly efficient market emphasize that abnormal returns cannot be expected regardless of the methods of analysis, strategies or past performance of investors.
In this lesson, we have covered the following:
* Two more important observations have been made in a perfectly efficient market with transaction costs:
* Analysts will be able to identify mispriced securities.
* Investors using a passive investment strategy do just as well.
The following observations have been made in a perfectly efficient market:
* Only a fair return on investments can be expected.
* Investors must believe that markets are not efficient.
* Publicly known strategies do not generate abnormal returns.
* Impressive performance is due to chance.
* Professional investors do not have any added advantage.
* Past performance is not an indicator of future performance.
In a perfectly efficient market:
* Investors who have the resources should rely on investment advisors for pricing decisions.
* Investment analysts will be highly regarded and actively pursued for their advice.
* Professional investors should fare no better in stock selection than the uninformed investors.
* Professional investors have an edge in generating abnormally high returns.
Professional investors should fare no better in stock selection than the uninformed investors.
* In a perfectly efficient market, prices always reflect investment value, and hence, professional investors do not have an edge over ordinary investors when it comes to stock selection. Therefore, investors need not rely on investment advisors or analysts for pricing decisions.
In perfectly efficient markets, the investors who profited in the past:
* Have a higher probability of profiting in the future
* Were most often lucky
* Learned valuable trading rules for the future
* Used professional advice
Were most often lucky
* Though some investment advisors or analysts may display impressive performance records, it is merely due to luck or chance. Their past performance cannot be relied upon as a basis for predicting their future performance.
