Market Efficiency Flashcards
Definition of efficiency
How accurate is the stock market at valuing the shares of a company
An efficient market = one where security prices reflect all information available
Information is rapidly included in minutes into share prices in an unbiased way
Reasons for market efficiency
Investor confidence
Motivation and control of directors to perform well
Efficient Market Hypothesis
Security prices fully reflect all information
Information is incorporated so quickly to asset prices so old information cannot be used to predict prices
Weak form efficiency
Share prices only reflect information about past price movements, which do not help in identifying positive NPV trades
Evidence: Share price random walks: there is no pattern, prices rise of fall without any correlation to news. Only 0.1% of a share price can be predicted by information
You cannot use technical analysis to predict future price movementsS
Semi-strong form efficiency
Share price reflects all past information and public information
Evidence: sahre prices rise and fall in response to good and bad news
Conclusion: fundamental analysis - examining public information won’t help beat the market
Only trading in the first few minutes after news can you beat a market
Published information is also weak. So weakly efficient
Strong form efficiency
Share price incorporate past, public and private information, including unpublished (e.g. insider dealing - directors)
Conclusions
If the market is semi strong:
Shares are fairly priced
Managers can improve share price and shareholder wealth by picking positive NPV projects and publishing about it
Most inventors (including fund managers) cannot beat the market without inside information
Market paradox
Investors really believe they can beat the market, so constantly analyse fundamentals and then the market reacts to these
Behavioural finance
Herding - following what other investors do
Stock market bubble - where herding inflates prices
Noise traders - do not base decisions on analysis, poorly timed
Loss aversion - low return safe investments
Momentum effect
