This is “Market Efficiency”, section 11.3 from the book Finance for Managers (v. 0.1). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (2 MB) or just this chapter (203 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).

Has this book helped you? Consider passing it on:
Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.
DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

11.3 Market Efficiency

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe the process of price discovery.
  2. Explain market efficiency.

Talking about risk only makes sense if we are dealing with uncertainty. If we truly are superior investors, able to always “pick the winners”, then we have no need to diversify significantly. For example, Bill Gates earned most of his fortune by owning a significant stake in one company (Microsoft).

A key difference, however, is that Bill Gates wasn’t just an investor, he was also the CEO for a significant portion of Microsoft’s history (and thus much more in control of the investment). And his tenure certainly wasn’t without uncertainty: for every Microsoft, Google, or Facebook there are numerous other companies that have failed, losing much of their investors’ capital. Unfortunately, many investors and managers only remember the success stories and forget those that lost their gamble. We constantly hear of these companies that were successful, but rarely hear of the former high-fliers of the internet bubble.

Furthermore, just as most people think they are “above-average drivers”, most investors are deluded into thinking they know more than everyone else in the market. Natural overconfidence, selective memory (we tend to remember our successes better than our failures), and a self-attribution bias (we tend to credit successes with skill but failures to “bad luck”) cause investors to believe they are better than they, in actuality, are. There is debate about whether Warren Buffett is a truly skilled investor, or whether he has “gotten lucky” because the market happened to fit his investment style during the years he was active. Given all of the numerous investors over the years, perhaps someone was bound to get as lucky as Buffett and make billions. Of course, many other investors were doomed to failure: many through lack of skill, but undoubtedly many also who were just “unlucky”. “It is better to be lucky than good” is a trading proverb that holds much truth.

Thus it is an open question whether skilled investors can reliably outperform the market. The argument for market efficiency goes as follows: investors sell or buy an asset based upon their valuation of the asset. This will cause the price to shift until the equilibrium price is reached (this process is called price discoveryThe process by which investors sell or buy an asset based upon their valuation of the asset. This will cause the price to shift until the equilibrium price is reached.). Once the proper price is reached, abnormal profits can no longer be earned. Furthermore, the market, in aggregate, has more information than any one investor could possibly have. The market price will be reached by this information, so an investor should not be able to abnormally profit from his or her private information. We call this the Efficient Market Hypothesis (EMH)The theory that the market, in aggregate, has more information than any one investor could possibly have. The market price will be reached by this information, so an investor should not be able to abnormally profit from his or her private information..

Studies have shown that those with insider knowledge (that is, material non-public financial information) about companies can profitably trade on this information, thus offering one refutation of complete market efficiency (in what we term the strong form of the EMHThe belief that all public and non-public information has been accounted for by the market. Those with insider knowledge (that is, material non-public financial information) about companies cannot profitably trade on the information if the market is strongly efficient.). Given that trading on insider information is typically against the law, this is of little benefit to the typical investor!

The semi-strong form of the EMHThe belief that all public information has been accounted for by the market (including financial analysis of released statements and analysts’ forecasts). If the semi-strong form is true, than investments based upon the fundamentals of a company shouldn’t be able to earn excess profits argues that all public information has been accounted for by the market (including financial analysis of released statements and analysts’ forecasts). If the semi-strong form is true, than investments based upon the fundamentals of a company shouldn’t be able to earn excess profits. Successful investors such as Warren Buffett and Peter Lynch are often put forth as counter-examples to the semi-strong form; proponents of the semi-strong form have put forth arguments that these investors were either lucky or had access to investment opportunities or information not available to the market as a whole. Other arguments against the semi-strong form include the existence of anomalies such as asset bubbles (such as the technology bubble and the real estate bubble) and post-earnings drift (the tendency for stock prices to not immediately jump to a new price based upon earnings surprise but slowly “drift” to their new level).

Most academics tend to embrace the semi-strong form, though many Wall Street traders reject it. One reasonable question to ask is, even if public information can be exploited for gain, can a typical investor access and make use of the data? Believers of the semi-strong form (or those who reject it but believe typical investors can’t benefit) advocate investing in “passive” broad market funds that don’t invest in particular companies based on analysis (unlike most “actively managed” funds).

Key Takeaway

  • If the market is at least semi-strong efficient, then analyzing public information won’t provide a trading advantage (since the price should already reflect all publically available data).

Exercise

  1. Jane believes that by calculating a company’s ratios from their past financial statements, she can deduce whether the company’s stock price is cheap or expensive. Does Jane believe the market is efficient?