Market efficiency

Kevin C.H. Chiang

Efficient market

 (Informationally) efficient market: a market in

which security prices adjust fully and rapidly
to the arrival of new information and,
therefore, the current prices of securities fully
reflect all available information about the
security.
3 sufficient conditions for an efficient
market (Fama)

 A large number of competing profit-

maximizing participants analyze and value
securities, each “independent” of the others.
 New information comes in a “random”
fashion.
 The competing investors attempt to adjust
security prices rapidly to reflect the effect of
new information.
3 forms of market efficiency, I

 Weak form: prices reflect all information

contained in the history of past trading.
Question: do past returns and prices predict
future returns?
3 forms of market efficiency, II

 Semi-strong form: prices reflect all publicly

available information (earnings, dividends,
PE ratios, book-to-market ratios, political
news, etc.)
Question: how quickly do prices reflect all
public information?
3 forms of market efficiency, III

 Strong form: prices reflect all relevant

information, including inside information.
Question: Do insiders make abnormal
returns?
Testing

 Does a known strategy produce consistently

abnormal returns after adjusting for
investment risk and transaction costs?
 No: the market is quite efficient.
 Yes: evidence against the EMH.
Implications, I

 In an efficient market, technical analysis is

useless.
 In a semi-strong form efficient market,
fundamental analysts (country analysts,
industry analysts, and company analysts), on
average, will not outperform the market.
Implications, II

 In a semi-strong form efficient market,

fundamental analysis is useless.
 In this market, a portfolio manager should:
(1) determine a proper level of risk tolerance,
(2) form a portfolio consisting of the risk-free
asset and a well-diversified risky portfolio
(passive management), and (3) minimize
taxes and total transaction costs.
Passive management

 No attempt to find undervalued securities.

 No attempt to time.
 Hold a well-diversified portfolio.
Active management/selection

 Believe that one can beat the market.

 Find undervalued securities.
 Time the market.