Efficient Market Hypothesis¶
- Market corrects itself when new info becomes available, through quick analysis and necessary price adjustments
- Prices fully reflect all available information
Market Efficiency¶
Represents only information-processing efficiency
No mis-pricings
- Good for investors
- Bad for speculators (Only mispricings will provide large gains. Just value investing provides nominal returns)
Reactions¶
| Type | |
|---|---|
| Under-reaction | Delayed |
| Efficient | |
| Over-reaction |
Forms of Efficiency¶
According to Fama, markets are neither purely inefficient nor purely efficient
| Inefficient | Weak | Moderate | Strong | |
|---|---|---|---|---|
| Market reflects __ info | None | historical | historical public | historical public private |
| Action Type | None | Overreaction | Pre-action | |
| Time | Before/at the time of announcement | |||
| Prices Characteristic | Random Walk | |||
| Implication | No relation between past prices and future prices No trading rule that depends on past can predict future Past prices do no provide any info to outperform the market | Incorporates WFH If an | ||
| Technical Analysis Applicable? | ✅ | ❌ | ❌ | ❌ |
| Fundamental Analysis Applicable? | ✅ | ✅ | ❌ | |
| Serial Correlation | ❌ | |||
| Momentum | ✅ | |||
| Studies | - Serial Correlation - Momentum/overreaction hypothesis | - Dividend declaration - Stock splits - Earnings announcement - Announcement of half-yearly results - Acquisitions & mergers - Announcements related to taxes | - Studies of corporate insiders - Specialists in stock exchanges |
Causes of Efficiency¶
- Sufficiently-large no of knowledgeable investors, who diffuse info
- Intense competition among investors
- Rapid transmission of information
- High speed of transactions
- Low cost of transactions
Causes of Inefficiency¶
Probability of mispricings in asset market \(\propto\)
- \(\dfrac{1}{\text{Ease of trading}}\)
- cost of information and transactions for exploiting inefficiency
Anomalies¶
That prove that no market is purely efficient
| Effect | |
|---|---|
| Size | Small stocks tend to give higher returns |
| January | Stock prices are higher in January |
| Small P/E | |
| Book Value to Market Value Ratio | |
| Reversal | |
| Market Momentum |