Market efficiency

economic-dictionary

Efficiency in any type of financial market is necessary for correct price formation. Financial markets are very broad, which is why they span many financial asset classes.

For a market to be efficient, two premises must be met:

  • Market information must be available at no cost to the investor.
  • The relevant information is reflected in the share price, bond, currency or interest rate.

Efficient markets hypothesis

There are three types of efficiency in markets according to the efficient markets hypothesis:

  1. Weak efficiency: It is based on historical prices, which reflect all the information contained in past prices. So the past information (volume and prices) have no predictive power on the future price of the securities, because prices are independent from one period to another. In a context of weak market efficiency, it is not possible to obtain risk-adjusted returns using technical analysis.
  2. Semi-strong efficiency: It also incorporates public information. Values ​​are quickly adjusted when information is made public. So the prices reflect all the public information available. This would imply that risk-adjusted returns could not be obtained through fundamental analysis.
  3. Strong efficiency: It is the efficiency that incorporates the previous two and private (internal) information. The prices not only reflect the history and public information, but also all the information that can be obtained by analyzing the company and the economy. This implies that no type of investor can access relevant information for prices, so that no one can constantly obtain excessive returns in the market.

Given the prohibition that exists in most markets on investing based on inside information it would be unrealistic to think that the markets are efficiently strong.

In many studies it has been shown that there is a weak form of efficiency. Past prices have no correlation with future prices. The prices turn out to be random. However, they do not support the fact that prices are right and therefore always correctly reflect intrinsic value. Therefore, there are also anomalies that reduce the credibility that markets are weakly efficient.

Behavioral finance argues for an adaptive markets hypothesis.

The 6 Lessons on Market Efficiency

  1. Markets have no memory. Past price changes do not reflect or have information about what will happen in the future. We have all heard many times of the famous phrase, «Past returns do not guarantee future returns«.
  2. Trust the market prices. When the market is efficient, it means that the price collects all the information available about the value of each asset.
  3. Learn to read the market before investing. There are many questions that must be resolved in order to know in what situation the market is, and by doing a good analysis, conclusions can be drawn for the future. What does a higher return mean? What projection does that company have? How is the interest rate curve? What signals does the market send us?
  4. There are no financial (accounting) illusions. There can be the case of creative accounting (which may or may not reflect changes in the price) or the case of split or counter split of shares, in which case, there is no loss of power or increase in it.
  5. Trust only yourself. A good investor would not pay another for something he can do.
  6. Very high elasticity of demand. The small changes in the variations of the price of an asset, suppose big movements in the demand of the same one.
Effectiveness

Tags:  economic-analysis Business Colombia 

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