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What Is Market Efficiency?

 

On the broad outlines, market efficiency is a degree level of availability of the information about the prices on the market.  For the first time this notion was introduced by Eugene Fama as a part of the Efficient Market Hypothesis (EMH). According to it, price formation takes into consideration all available information so no trader can cut ahead of the market.

The higher the efficiency is, the more information about trading opportunities is available and the more transactions can be made without increase of the transaction costs.

Versions of Efficient Market Hypothesis

Not all traders and degreed experts support Fama’s hypothesis and some specialists tend to assume middle position. As a result, at the moment there are three points of view:

  • Passive investor believes that this hypothesis is more like an axiom. Meaning that all available information is taken into consideration in the price formation and even insider information won’t give an advantage to any trader.
  • Value investors who do not support this hypothesis think that there is a possibility to earn lots of money due to the situations where some stocks may become undervalued so they wait for the time when the price for the stock drops and buy it to sell it when the price goes up
  • Semi-strong point of view supports neither passive nor value investors’ approach thinking that the truth is somewhere in the middle of these two opinions. Thus any tech tool is able to provide solutions how to beat the market.

 Why it is non-predictable?

When it comes to the information that has an influence on trading, you will be surprised how many sources of information are taken into consideration and what spheres apart from financial field does it cover. Here everything plays an important role: political, economic and social events, geopolitics, sometimes even weather conditions can influence the pricing. Add here the psychological factor – how investors take any important information, news and rumors and you will get a full picture how the prices are formed on the market. All traders have equal opportunities in terms of information availability according to the hypothesis. As a result, at the efficient markets it is impossible to predict the price movement, making all investment strategies unproductive.. That is why, according to the supporters of EHM it is more advantageous to invest into an index fund.

What markets can become efficient?

By one of the ironies of history, all strategies that are aimed to make a profit from the inefficiency of the market are the reason why the markets become efficient.  Here investors should believe that there is a possibility to take an advantage of the lack of information about certain stock. The more trades are made with the stock, the more financial information appear on the market and all participants of the trades receive an access to it and as a result the inefficiency disappears and the market becomes efficient.

What tells against the EMH?

There are several pieces of evidence that the EMH is not always correct. Many investors from the Forbes 500 made their fortunes using the undervalued stocks – and they show that there is still a possibility to beat the market.

In addition, it is clear that there are trading patterns that actually work, despite the fact that the EMH declares that no strategy can be successful in the conditions of efficient market with random prices. Plus, behavioral finance in whole is an argument against the EMH.

Still, no one today can say with confidence that there are no markets that can be classified as purely in/efficient, however, with the Internet and access to information of all kinds the level of efficiency rises exponentially.

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