7.4 Evidence of Market Efficiency

 7.4 Evidence of Market Efficiency

Sophisticated statistical analyses of stock and other securities prices indicate that they follow a “random walk.” 

If securities prices in efficient markets are not random, and determined by fundamentals, particularly interest rate, inflation, and profit expectations. Why is random is their direction, up or down, in the next period?

That’s because relevant news cannot be systematically predicted. (If it could, it wouldn’t be news.) 

So-called technical analysis, the attempt to predict future stock prices based on their past behavior, is therefore largely a chimera. On average, technical analysts do not outperform the market. 

Three types of market efficiency: weak, semi-strong, and strong. Today, most financial markets appear to be semistrong at best.

In every age, financial markets tend to be more efficient than real estate markets, commodities markets, labor, and many services markets because financial instruments have a very high value compared to their weight, uniform quality, and little subject to wastage.

Futures markets have arisen to make commodities markets more efficient. 

Mortgage markets, also help to improve the efficiency of real estate markets.

Labor and services markets are the least efficient of all. People won’t or can’t move to their highest-valued uses; they adapt very slowly to technology changes; and regulations imposed by governments and others by labor unions, limit their flexibility on the job. 

Markets for education, healthcare, and custom construction services are also highly inefficient due to high levels of asymmetric information.

Many legitimate companies try to sell information and advice to investors. The value of that information and advice, however, may be limited. 

Even if the research is unbiased and good, by the time the newsletter reaches you, even if it is electronic, the market has probably already priced the information, so there will be no above-market profit opportunities remaining to exploit.

Only one investment advice newsletter, Value Line Survey (VLS), has consistently provided advice that leads to abnormally high risk-adjusted returns.

It isn’t clear if VLS has deeper insights into the market, if it has simply gotten lucky, or if its mystique has made its predictions a self-fulfilling prophecy: investors believe that it picks super stocks, so they buy its recommendations, driving prices up, just as it predicted! 

January Effect, the predictable rise in stock prices that for many years occurred each January until its existence was recognized and publicized. 

Financial securities, including stocks, tend to overshoot when there is unexpected bad news. After a huge initial drop, the price often meanders back upward over a period of several weeks. This suggests that investors should buy soon after bad news hits, then sell at a higher price a few weeks later. 

Sometimes, prices seem to adjust only slowly to news, even highly specific announcements about corporate profit expectations. That suggests that investors could earn above-market returns by buying immediately on good news and

selling after a few weeks when the price catches up to the news. 

The small-firm effect, returns on smaller companies, are abnormally large. Why then don’t investors flock to such companies, driving their stock prices up until the outsized returns disappear? Some suspect that the companies are riskier than researchers believe. 

The most important example of financial market inefficiencies is so-called asset bubbles or manias.

Periodically, market prices soar far beyond what the fundamentals suggest they should. During stock market manias, like the dot-com bubble of the late 1990s, investors apparently popped sanguine values forg into models like the Gordon growth model.

Our brains are pretty scrambled, especially when it comes to

probabilities and percentages. 

Behavioral finance uses insights from evolutionary psychology, anthropology, sociology, the

neurosciences, and psychology to try to unravel how the human brain functions in areas related to finance. [10] For example, many people are averse to short selling, selling (or borrowing and then selling) a stock that appears overvalued with the expectation of buying it back later at a lower price.

Human foible is that we tend to be overly confident in our own judgments. Many actually believe that they are smarter than the markets in which they trade.

Another source of inefficiency in financial markets is asymmetric information, when one party to a transaction has better information than the other.

Greater transparency and more fervent attempts to overcome the natural limitations of human rationality would help to move the markets closer to strong form efficiency.

References

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under

      Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.  

      Available from: https://www.saylor.org/site/textbooks/Money%20and%20Banking.pdf

How Do Information Systems Affect Market Efficiency?

 How Do Information Systems Affect Market Efficiency?

As we already know that the demand and supply are the reasons why stock prices are fluctuating like waves on the sea. And we also know that multiple factors would influence the waves' upper and drop. According to the price theory, if the market price of anything differs from the equilibrium price, market participants will bid the market price up or down until equilibrium is achieved. However, the equilibrium price is determined by the demand and supply which means they are influenced by factors like the prices of alternative goods, expectations, technology, income, preferences, the number of participants, natural events, government, regulations, and more. 

To Know The Price of Relative Investment Are Available

As we also know, these factors are also hugely influenced by information technology. For example, the prices of alternative goods, how do know that somewhere, has a cheaper alternative good that can increase your return before we have Google, the internet? Without these tools, how can you quickly get that kind of information to adjust your investment and your portfolio? It may take days or even longer for everyone to make a wise decision with poor information technology. Today, real-time news or podcasts can give you some pieces of information although they are not always right. But they do reduce the time we need to search for relative information and help us make decisions more quickly.

Expectations

How do predict the future of the price a stock and invest it before it becomes the next Tesla? You make your prediction and imagine the future with your own model. But how much information do you have in your brain? Or, just a dream? Information technology helps us make much more "real" decisions instead of just predict the dream can true.

The Number of Participants 

Recently, a very popular app called Robinhood helps many young and first-time traders in the US to build their first portfolios. The app helps tons of traders to quickly trade on the move with a single click and confirm, and hugely upsized the liquidity of the capital investment. Investors who value any particular asset most highly will click the buy button to own it, and more and more people have the opportunity to pay the most for it, therefore allocationally efficient. 

Reference
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

7.3 Financial Market Efficiency

 7.3 Financial Market Efficiency

If the market price of anything differs from the equilibrium price market participants will bid the market price up or down until equilibrium is achieved. 

The investor who values the asset most highly will come to own it because he’ll be willing to pay the most for it. Financial markets are therefore allocationally efficient. 

Where free markets reign, assets are put to their most highly valued use, even if most market participants don’t know what that use or value is. 

Financial markets are also efficient in the sense of being highly integrated which means prices of similar securities, or assets track each other closely over time, and prices of the same security trading in different markets are nearly identical.

Arbitrage, the profit opportunity that arises when the same security at the same time has different prices in different markets. By buying in the low market and immediately selling in the high market, an investor could make easy money. 

As soon as an arbitrage opportunity appears, it is immediately exploited until it is no longer profitable. (Buying in the low market raises the price there while selling in the high market decreases the price there.) Therefore, only slight price differences that do not exceed transaction costs persist.

The size of those price differences and the speed with which arbitrage opportunities are closed depending on the available technology. 

The transaction costs (fuel, tolls, hotels, and fees) are too high explains why people don't arbitrage the international price differentials of Big Macs, or any other physical things. However, online sites like eBay, or Amazon have recently made arbitrage in nonperishables more possible than ever by greatly reducing transaction costs.

After carefully studying all the transaction costs, the freight, insurance, brokerage, weighing fees, foreign exchange volatility, weight lost in transit, even the interest on money over the expected shipping time, the unit, the British ton (long ton, or 2,240 pounds), and the U.S. ton (short ton, or 2,000 pounds) are not the same thing. 

However, arbitrage and other unexploited profit opportunities do exist on occasion, not completely impossible.

In an efficient market, all unexploited profit opportunities and arbitrage opportunities, will be eliminated as quickly as the current technology set allows. 

In an efficient market, the optimal forecast return and the current equilibrium return are one and the same. For example, the rate of return on a stock is 10% but the optimal forecast or best rate of return, due to a change in information, was 15%. Investors would quickly bid up the price of the stock, thereby reducing its return. 

Financial market efficiency means that it is difficult or impossible to earn abnormally high returns at any given level of risk while returns increase with risk. 

Holding risk (and liquidity) constant, though, returns should be the same, especially over long periods. 

Many studies have shown that actively managed mutual funds do not systematically outperform the market.