Capital Market Efficiency

Efficiency as it relates to capital markets occurs when share prices at all times reflect all available relevant information. From the above, we can deduce that if a market is efficient, any new information available in the market which relates to a security of a particular firm will be incorporated into the share price speedily and rationally.

Perfect Capital Market

Perfect capital market assumes a complete market, perfect rationality of investors with many of them being price takers, and availability of information at no cost to participants, and instantaneous and costless transactions where taxes are non-existent.

Efficient Capital Market

In real life, all the assumptions given under the perfect capital market may not be realistic. Rarely would you find a truly perfect capital market, and this is mainly because of transaction costs. An efficient capital market is more realistic, and we take three assumptions from the perfect capital market to form our efficient capital market theory. These assumptions are:

• Participants or investors are rational and would adjust security prices rapidly to reflect the effect of new information.
• Participants are price takers and prices are determined as a result of competition and movement in the demand and supply of a security as result of new and available relevant information about the security.
• New information regarding securities is available at no cost, and security prices adjust to all new information.

Attributes of an efficient capital market

• Allocation Efficiency: This means there is efficiency in the allocation of resources to investments. We believe that in an efficient capital market, scarce saving resources are optimally allocated to the most productive investment in a manner that benefits all. This means that share prices are determined in a way that equates the marginal rates of return for all lenders and borrowers.

• Pricing Efficiency: In an efficient capital market, security prices that prevail at any time should reflect all available relevant information. It means that prices should be an unbiased reflection of all currently available information and also the risk inherent in holding that security.

• Operational Efficiency: Market intermediaries provide the service of channeling funds from savers to borrowers at a minimum cost that gives them a fair return for their services. Remember in the discussion under perfect capital market, we said one of the assumptions of a perfect capital market is that there are no transaction costs and that is one of the chief reasons why it is impracticable. Well under the efficient capital market, transaction costs are expected, but at the lowest minimum cost.

• It is believed that no change occurs in wealth distribution. This means that no individual should make more than average returns from trading in the market.

Efficient Market Hypothesis

Efficient market hypothesis states that asset prices fully reflect all available information. This theory believes that it is impossible for investors to beat the market consistently on a risk adjusted basis because stock price only reacts to new information and changes in discount rates.  Efficient market hypothesis was formulated by professor Eugene Fama who believed that stocks always traded at their fair value, so it is impossible for investors to find undervalued to buy or to sell stocks at inflated prices for profit. He also believed that expert research and stock selection, as well as market timing strategies would not help investors outperform the overall market; the only way investors can obtain higher returns is by chance or by purchasing a riskier investment.

There are three variants in the efficient market hypothesis, and today we would be taking a look at each of them. The variants are weak, semi-strong and strong form.

Weak-form Efficiency: Weak form efficiency implies that any information which might be contained in past price movements is already reflected in the share prices. This means that share prices reflect all available information contained in the records of past prices. Weak form efficiency believes that historical prices cannot help in predicting future prices, and excess returns cannot be earned in the long run by implementing investment strategies based on historical price or data.

Technical analysts study historical movement in stock prices in an attempt to determine the direction or trend the stock prices will continue with in the future. Technical analysts use dealing rules trade attempted to take advantage of buying and selling shares according to the direction of the deviation or breakout, but there is no evidence that investors make abnormal returns from applying these rules. The weak form efficiency agrees with this because according to the weak form efficiency, historical information is already reflected in the share price, so technical analysts have no edge in predicting future prices because they deal mainly with the study of historical movement in stock prices. Fundamental analysis on the other hand which involves the valuation of the company to predict its stock price may provide excess returns under the weak-form efficiency.

To reiterate, the reason for the failure of technical analysis to provide excess return in weak form efficiency is that share price exhibit no serial dependencies, this means that share price changes are random because investors are themselves rational and offer competitive prices. This implies that future price movements are determined entirely by information not contained in the price series.

Semi Strong Form Efficiency: semi-strong form efficiency implies that all relevant publicly available information is reflected in the share price. In the semi strong form efficiency, it is believed that share prices reflect all information not only incorporated into past prices, but also all publicly available information regarding the company whose stock is being traded. Information such as announcements of earnings forecasts, mergers and acquisitions, divestitures, and changes in accounting policies is reflected rapidly in the share price. From the above we can say that in strong-form efficiency, share prices reflect almost instantaneously, publicly available new information in an unbiased fashion, meaning that no excess return can be earned by trading on that information.

This implies that neither fundamental analysis nor technical analysis would be able to reliably produce excess returns.

Strong form Efficiency:  Strong form efficiency implies that all relevant information including those which are only available to those in privileged positions are fully reflected in share prices. This form of efficiency believes that there is no way to earn excess returns based on both public and private information. Fundamental and technical analyses are useless according to this form of efficiency, as there is no relevant private information in determining share prices. So whether you are a professional investor or a fund manager, your fundamental analysis can’t do much to earning you excess revenue.

However, evidence is available that insiders or those with privileged access to information about a firm as well as professional investors can and do exploit information not generally available to the public to their own advantage. This means that strong form efficiency is not realistic in capital markets.

Recommended Readings

Frank Fabozzi.,The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies

Burton G. Malkiel., A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing