Summary:
Market efficiency is an economic concept that describes how financial markets quickly and accurately incorporate all relevant information into asset prices. In an efficient market, prices reflect all available information and investors find it difficult to consistently achieve above-average returns. In this blog, we are demystifying this concept and giving you opinions from all sides.
Financial markets constantly respond to changes and keep adjusting the pricing accordingly. Although every share bought or sold, every single financial news, and rumour influences the pricing, the market takes all these factors into account simultaneously when deciding the pricing.
The "Efficient Market Hypothesis" aka EMH is one of the prominent economic theories that explains this ever-changing pricing. According to this concept, stock prices always accurately represent all relevant data, preventing either under- or overvaluation.
Naturally, the EMH has its critics, just like any other theory. But what difference does it really make, and what do experts think about its reliability? Let's dive in to explore the nuances of this important economic concept:
Basics of Market Efficiency
The term "market efficiency" was first used in a study made by renowned economist and Nobel laureate Eugene Fama in 1970.
As mentioned earlier, The Efficient Market Hypothesis (EMH) posits that stock prices fully reflect all available information. In such a market, no investor has an advantage over others in predicting stock price movements, as all known data is already incorporated into the current prices.
Here are some of the features of an efficient market:
- Reflective: Prices mirror all known information.
- Reactive: As soon as new details emerge, the market responds.
- Unpredictable: It's tough, if not impossible, for investors to consistently outdo the market.
Unchangingly, this implies that consistently "beating the market" is challenging because stocks are always priced fairly.
How Efficiency Materialises in the Market
Despite sounding paradoxical, investors should first believe that the market has inefficiencies for it to be truly efficient.
Why? Because it's their attempts to take advantage of these perceived gaps that end up balancing the scales, ultimately leading to actual market efficiency. Like tug-of-war, the rope stays centred as long as both sides pull with equal strength.
Similarly, when investors act on their perceptions, they help in adjusting the stock prices, ensuring that the price reflects all available information.
Simplifying Market Efficiency: The Three Forms
Market efficiency can be broken down into three distinct forms, each with its unique approach to how information is reflected in stock prices:
Weak Form Efficiency Definition
This form suggests that all past market data, such as prices, are fully reflected in stock prices.
Semi-Strong Form Efficiency Definition
This stratum believes that stock prices adjust quickly to new public information.
Strong Form Efficiency Definition
Here, stock prices reflect all information, both public and private.
The ‘Why’ Differing Opinions
Here’s what drives the divide between promoters and detractors of the EMH:
For the Believers
These people argue that with today's technology, information spreads so fast that prices adjust almost immediately. They'd point out India's rapid digitalisation, with many apps providing real-time data to millions.
For the Sceptics
Ever heard of market bubbles like the dot-com boom? Sceptics argue that, if markets are so efficient, how come such bubbles occur? They suggest that human emotion, such as fear or greed, has a role in distorting the prices.
Active vs. Passive Investors: Two Sides of the Same Coin
When it comes to market efficiency, two schools of thought clash like the timeless debate of chai vs. coffee. Active investors, with their extensive research and strategies, try to outperform the market.
They're the ones placing bets on individual stocks or sectors. On the flip side, passive investors trust in the market's efficiency. For them, it's not about beating the market but riding its wave. They often park their funds in broader market instruments like index funds or ETFs, in a bid to harness the overall market's performance.
Interestingly, while passive players believe that consistently outdoing the market is a far-fetched idea, history has shown instances where keen-eyed investors have managed to score higher returns than the market average.
Indian Examples: Illustrating Efficiency
Demonetisation Effect: In 2016, when PM Narendra Modi announced demonetisation, stock markets reacted almost instantly. The BSE Sensex plummeted, reflecting the anticipation of reduced consumer spending.
Reliance Jio's Entry: The telecommunications stocks experienced a massive shock when Jio entered with free offerings. Other telecom stock prices adjusted swiftly in response.
Uncomplicating Market Efficiency
Put simply, market efficiency involves more than just price modifications or information distribution. Instead, it is about the dynamic interaction of a variety of elements ranging from investor behaviour to technical improvements to external news and events.
In fact, predicting the market's future moves would be extremely difficult if the market fully mirrored all available information! But as many seasoned traders would say, the market might seem unpredictable but it's not entirely random.
Key Points to Remember:
All in all, market efficiency is about how fast prices reflect information. It has three forms: weak, semi-strong, and strong. Expert opinions on market efficiency vary, with clear arguments on all sides. Investors must also remember the impact of real-life events, like demonetisation, on the market which offer glimpses into market reactions and help us etch out the key tenets of efficiency.