Investment & Equity Research: Market Efficiency

Investment &
Equity Research
Market Efficiency
Market Efficiency_10 1
Topics Covered
Market Efficiency
The Efficient Market Model
Observations About Perfectly Efficient

Markets
Market Efficiency
It basically refers to external market efficiency. It is
also known as “Informational Efficiency”.
Externally Efficient Market
In this type of market, information is quickly and widely
disseminated which allows all security’s price to adjust
rapidly in an unbiased manner to new information so
that it reflects investment value.
Internally Efficient Market
It is one in which brokers compete freely, making the
cost of transaction low and the speed of transacting
high. Market Efficiency_10 3
The Efficient Markets Model
In efficient market, every security’s price equals its

investment value at all times, will exist.
i.e. a market is efficient with respect to a particular set
of information if it is impossible to make abnormal
profits (other than by chance) by using the set of
information to formulate buying and selling decisions.
As per Eugene Fama, we have
Form of Efficiency Set of information reflected

In security’s prices
Weak Previous prices of securities
Semi strong All publicly available information
Strong All information, both public and
private
i.e. in an efficient market, investors should expect to
make normal profits by earning a normal rate of return
on their investment.
Weak Form
A weak-form efficient market would be one in
which it is impossible to earn abnormal profits
(other than by chance) by using past prices to
make buying and selling decisions.
Semi Strong- Form
A semi strong- form efficient market would be
one in which it is impossible to earn abnormal
profits (other than by chance) by using publicly
available information to make buying and
selling decisions.
Strong Form
A strong-form efficient market would be one in
which it is impossible to earn abnormal profits
(other than by chance) by using any
information whatsoever to make buying and
selling decisions.
Note:
1. When people refer to efficient markets, they usually

refer to semi strong-form efficient markets (because
the use of insider information is prohibited to make
buying and selling decisions).
2. “Other than by chance” refers to the situation just

as someone who wins a lottery after using a method
for picking a number but does not necessarily have
a successful method for picking winning lottery
numbers.
Note:
3. If markets are strong- form efficient, they are also

semi-strong and weak- form efficient. Similarly, if
markets are semi strong-form efficient, they are
also weak-form efficient.
4. Security price changes are random in a perfectly

efficient market. As information arrives randomly,
hence price changes (positive/negative) are simply
the result of investor’s reassessing a security’s
prospects and adjusting their buying and selling
appropriately. Thus, price changes are random but
rational. Market Efficiency_10 10
Note:
5. In an efficient market, a security’s price is a good
indicator of its investment value.
i) If security price is less than its investment value

then it will be purchased creating pressure for
price increase caused by the increased demand
to buy and vice-versa.
ii) As investors seek to take advantage of

opportunities created by temporary inefficiencies,
the inefficiencies are reduced and the less alert
investors have a less chance to obtain large
abnormal profits Market Efficiency_10 11
Observations About Perfectly Efficient Markets
1. Investors should expect to make a fair (or normal)
return on their investment but no more.
2. Markets will be efficient only if enough investors

believe that they are not efficient. (Assuming this,
no investor will invest because there is no gain).
3. Publicly known investment strategies cannot be

expected to generate abnormal returns. (revealed
strategy will not have the same level of return).
4. Some investors will display impressive performance

records.(impressive performance merely due to
chance).
e.g.:
Assume a market where half the time, the market is
up and half the time, the market is down. i.e. Half of
the investors will be right in any given year and half
will be wrong.
Year Investors
Year 1 ½
Year 1&2 ¼
Year1,2&3 ⅛
Thus, (1/2)T investors will be correct every year over

a span of T years. It’s only because they are lucky,
not because of being skillful.
5. Professional investors should fare no better in
picking securities than ordinary investors.
(In an efficient market, prices always reflect
investment value. Thus, the search for mispriced
securities are futile).
6. Past performance is not an indicator of future

performance.
(As past luck and misfortune do not have a
tendency to repeat them, historical performance
records are useless in predicting future
performance records).
Observations About Perfectly Efficient
Markets With Transaction Costs
Let us assume that investors cannot adjust their
portfolios in response to new information without
incurring transaction costs. Having considered the
fact that access to information requires transaction
costs, Sanford Grossman and Joseph Stieglitz arrive
at following conclusions:
1. In a world where it costs money to analyse
securities, analysts will be able to identify
mispriced securities.
→ Their gain from doing so will be exactly offset
by the increased costs they incur. Their gross
returns will indicate abnormal returns but their
net returns will show a fair return and nothing
more.
→ Rapid buying or selling will incur more
transaction costs.
2. Investors do just as well using a passive
management strategy where they simply buy
securities in a particular index and hold on to
the investment.
→ The gross returns of professionally managed
portfolio will exceed those of passively
managed portfolios having similar investment
objectives that the two kinds of portfolios can
be expected to have similar net returns.
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Investment &

The Efficient Market Model

Observations About Perfectly Efficient

In efficient market, every security’s price equals its

Form of Efficiency Set of information reflected

1. When people refer to efficient markets, they usually

2. “Other than by chance” refers to the situation just

3. If markets are strong- form efficient, they are also

4. Security price changes are random in a perfectly

i) If security price is less than its investment value

ii) As investors seek to take advantage of

2. Markets will be efficient only if enough investors

3. Publicly known investment strategies cannot be

4. Some investors will display impressive performance

Thus, (1/2)T investors will be correct every year over

6. Past performance is not an indicator of future

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