What is the concept of market efficiency?

Efficient markets refer to financial markets where asset prices reflect all available information. In an efficient market, it is assumed that prices fully and quickly incorporate all relevant information.

The Efficient Market Hypothesis (EMH) suggests that, in an efficient market, it is not possible to consistently outperform the market by using historical price data or other public information. "You can't beat the market." Investors should use a?passive investment?strategy because?active investment?strategies will underperform due to transactions costs and management fees. However, to the extent that market prices are inefficient, active investment strategies can generate positive risk-adjusted returns.

One method of measuring a market's efficiency is to determine the time it takes for trading activity to cause information to be reflected in security prices (i.e., the lag from the time information is disseminated to the time prices reflect the value implications of that information). In some very efficient markets, this lag is very short. If there is a significant lag, informed traders can use the information to potentially generate positive risk-adjusted returns.

Professor Eugene Fama originally developed the concept of Efficient Market Hypothesis (EMH) and identified three forms of market efficiency.

a) Weak Form : Assumes that all past trading information is already reflected in stock prices.

b) Semi-Strong Form : Assumes that all publicly available information, including both historical and current information, is already reflected in stock prices.

c) Strong Form : Assumes that all information, public and private, is fully reflected in stock prices.

Given the prohibition on insider trading in most markets, it would be unrealistic to expect markets to reflect all private information. The evidence supports the view that markets are not strong-form efficient.

■ Market anomalies.

Efficient market theory has been the subject of extensive debate and criticism, and some argue that markets are not perfectly efficient due to factors like behavioral biases, informational asymmetry, and other market inefficiencies.

Market anomalies refer to observed patterns or behaviors in financial markets that seem to deviate from the efficient market hypothesis (EMH). Theses anomalies imply that certain market patterns or behaviors can be exploited to generate abnormal profits. Some common market anomalies include:

■ Calendar Effects :

o January Effect : The tendency for stock prices to rise in the month of January, often attributed to tax-related selling in December and subsequent buying in January.

o Day-of-the-week Effect : Historical evidence suggests that stock returns may vary depending on the day of the week, with some days consistently exhibiting higher returns than others.

o?Turn-of-the-Month Effect : Stock returns tend to be higher around the turn of the month, possibly due to factors such as cash inflows from salary payments and fund distributions.

■ Price Patterns:

o?Momentum Effect : The observation that assets that have performed well in the past tend to continue performing well in the future, and vice versa.

o?Value Effect : Stocks with low price-to-earnings (P/E) or price-to-book (P/B) ratios may outperform stocks with high ratios over the long term.

■ Others Market Anomalies in Behavioral Finance :

o?Overreaction and Underreaction : Investors may overreact to new information, causing prices to move too much, or they may underreact, creating opportunities for profitable trades.

o Herding Behavior : The tendency of investors to follow the actions of the crowd rather than conducting independent analyses, leading to market inefficiencies.

■ Small-Cap Effect : Small-cap stocks have historically outperformed large-cap stocks over the long term.

It's important to note that while anomalies suggest market inefficiencies, they do not guarantee consistent profits, as markets can adapt and adjust over time. Investors and researchers often debate the significance of these anomalies and whether they can be exploited systematically or if they are simply the result of statistical noise. Additionally, anomalies may diminish or disappear as more investors attempt to capitalize on them, contributing to market efficiency.

■ Behavioral finance to understand market anomalies.

Behavioral finance examines the decision-making processes of investors. Behavioral finance does not assume that investors always act rationally. Investors appear to exhibit bias in their decision making :

• Loss aversion. Investors dislike a loss more than they like a gain of an equal amount. This may help to explain under-reaction and overreaction market anomalies.

• Investor overconfidence. Investors overestimate their abilities to analyze security information and identify differences between securities' market prices and intrinsic values.
• Herding. Investors to act in concert on the same side of the market, acting not on private analysis, but mimicking the investment actions of other investors.
• An?information cascade?results when investors mimic the decisions of others.

Market efficiency does not require all market participants to act rationally as long as the market acts rationally in aggregate. If the market can adjust for irrationality quickly, then behavioral finance does not necessarily contradict market efficiency. However, if the market allows its participants to earn abnormal returns from the irrationality of others, then the market cannot be efficient.