Market efficiency and its forms
While explaining the concept of market efficiency, it’s said that an efficient market is the one in wherein asset prices tend to reflect any new information quickly and rationally. In an efficient market, asset prices reflect all past and present information. The time period of ‘quickly’ is defined by trades since it is via the trading mechanism in which new information can be incorporated into asset prices reflecting the impact of the new information on asset prices. Hence, the time period needed for an asset’s price to incorporate information is equivalent to the minimal time required by a trader to execute a transaction in a particular asset.
Market efficiency is an interesting topic for investment managers and analysts as the extent to which a market is efficient affect how many profitable trading opportunities exist in the market. While buying and holding a broad market portfolio best suits an efficient market, inefficient markets create opportunities for an active investment strategy so as to achieve superior risk-adjusted returns.
To understand the degree to which a market is efficient, American economist Eugene Fama had developed a framework describing that markets are efficient when asset prices reflect all relevant information at any point in time.
As per the framework, in a strong-form efficient market, security prices fully reflect both public and private information. It is said that in a strong-form efficient market, insiders would not be able to earn abnormal returns from trading on the basis of private information as the asset prices will reflect everything that the management of the company knows including information that has not been publicly revealed. However, research has shown that is not the true case and in reality, securities markets are not strong-form efficient since abnormal profits can be earned when non-publicly disclosed information is used by insider investors. While strong prohibitions against insider trading are found in most countries, it is still practically impossible for a perfectly strong-form efficient market to exist in reality.
On the other hand, in a weak-form efficient market hypothesis, security prices tend to fully reflect all past market data including all historical prices and trading volume information. In simple terms, in a weak-form efficient market, the past trading data or the past news information has already been accounted for in the current prices and investors cannot predict the future price changes by studying patterns of past prices or others. An alternative approach to this would be the study of technical analysis wherein analysis of historical trading information is conducted so as to identify and point out recurring patterns in the trading data which can be further used as a guide to investment decisions. Though not every time earning abnormal returns with the support from the technical analysis is possible since stock prices are largely influenced by investor psychology as well, which may not remain the same during every recurring event.