Market Efficiency

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What is the efficiency of the market

Market efficiency means the degree to which market prices reflect all available relevant information. If markets are efficient than all the information already incorporated in prices, and therefore there is no way to “beat” the market, because there is no under – or overvalued securities. Market efficiency was developed in 1970 by economist Eugene Fama whose theory, efficient market hypothesis (GER) stated that it is not possible for an investor to outperform the market, and stock market anomalies should not exist, because they will be immediately arbitraged away. Later, Fama received the Nobel prize for their efforts. Investors who agree with this theory, as a rule, buying index funds that track the overall performance of the market and supporters of passive portfolio management.

In essence, the effectiveness of market measures the market’s ability to incorporate information that provides the maximum number of opportunities for buyers and sellers of securities transactions without increasing operational costs. If markets such as the US stock market is effective, and to what extent is hotly debated among scholars and practitioners.

Penetration market efficiency

There are three degrees of market efficiency:
Weak form market efficiency implies that recent price fluctuations do not affect future prices. Given this assumption, the rules of momentum or technical analysis that some traders use to buy or sell shares are invalid. Semi-strong form market efficiency implies that stocks to adapt quickly to absorb new public information, so that investors cannot take advantage of the market, trading on this new information. Strong form market efficiency States that market prices reflect all information, both public and private, given the weak form and semi-strong form. Given the assumption that stock prices reflect all information (public and private) that no investor, including a corporate insider, will be able to profit above the average investor even if he was involved in a new insider information. Several statistical and applied tests designed to check the degree of efficiency in the market.

Different beliefs of efficient market

Investors and scientists have a wide range of points of view on market efficiency, which is reflected in the strong, semi-strong and weak versions of the EMH. Believing that the market is strong and those who agree with Fama, and often consist of passive index investors. Practicing the weak version of the EMH believe active trading can generate profit via arbitrage, and semi-strong believers somewhere in the middle.

For example, at the other end of the spectrum from Fama and his followers-investors who believe that stocks can become undervalued, or at a price lower than they really are. Successful value investors make their money by buying stocks when they are undervalued and sell them when their price rises to match or exceed their actual value.

People who do not believe in the efficient market point to the fact that there are active traders. If there is no opportunity for profit that beat the market, then there should be no incentive to become an active trader. In addition, fees charged by active managers taken as proof the EMH is not correct, since it assumes that an efficient market has low transaction costs.

Example of effective market

Although there are investors who believe in both sides of the EMH, there is real evidence that wider dissemination of financial information affects securities prices and makes the market more efficient. For example, the adoption of the Sarbanes-Oxley act of 2002, which requires greater financial transparency for publicly traded companies, there was a decline in the volatility of the stock market after the company published a quarterly report. It was established that financial statements are considered more reliable, making the information more authentic and create greater confidence in the stated value of the security. There are fewer surprises, so the reaction to earnings reports is smaller. This change in the pattern of volatility shows that the adoption of the Sarbanes-Oxley act and its information requirements have made the market more efficient.

Other examples of efficiency occurs when perceived anomalies in the market have gained prominence and subsequently disappear. For example, it was once the case, when the stock was added to such an index, like the S&P 500 for the first time, there would be a big boost to the fact that the price of a stock simply because it entered into the composition of the index, not because of any new changes in the fundamentals of the company. The effect of the index on the anomaly became widely known and famous, and since then has virtually disappeared as a result. This means that with increasing information, the markets become more efficient and to reduce anomalies.

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