Market efficiency is the concept that markets have synthesized all available knowledge into the prices. Thus, the prices reflect that knowledge. By extension of this, there is little that an investor can do to "beat" the market -- that is to outperform market returns on a risk-adjusted basis. The theory of market efficiency is best encapsulated in the Efficient Market Hypothesis. This paper will explain market efficiency in detail and outline how understanding market efficiency can help investors to maximize shareholder wealth.
Heakal (2009) explains that Eugene Fama first proposed the efficient market hypothesis (EMH) in 1970. The EMH is based on the idea that "at any given time, prices fully reflect all available information on a particular stock and/or market" (Ibid). A perfectly efficient market will account for all publicly available information that can have an impact on the stock price. This information can be about the stock -- details about the performance of the firm, for example. The information can also be about the circumstances in the external environment that affect the company. Thus for example when something happens in the macroeconomic, political or regulatory environment that can impact on the price of the stock, that information will be processed nearly instantly by the market, so that the asset's new price fully reflects that information. Market participants estimate the impact of any changes when they re-adjust the price of that asset. This process happens more quickly when the market has a higher degree of liquidity so for most major U.S. stocks the process happens nearly instantly and for global markets such as those for sovereign debt, currencies or commodities the changes are registered by the market instantly. The end result is that the price of an asset in the market right now reflects all of the information that is available about that asset right now.
In efficient market hypothesis, there are different levels of market efficiency. These different levels reflect different interpretations of the concept of perfect information. Weak-form efficiency simply reflects past stock prices in today's stock price. Semi-strong efficiency holds that all publicly available information is incorporated into the current price of the asset. Strong-form efficiency argues that the market has processed all information -- both public and private -- into the stock price. Under this assumption, some market participants must have inside knowledge in order to make adjustments to the price of the stock. Therefore even having this inside information in insufficient to give an investor an advantage, since it has already been priced into the stock.
Market efficiency, however, rests on a set of assumptions. The first such assumption is perfect liquidity. Few markets can claim this, yet liquidity is an imperative aspect of market efficiency. Information is processed through a large number of actors, not the least because each actor must interpret the impact of the information on the stock's price. Each interpretation will be unique. Stock prices are, in a rational world, the net present value of future cash flows expected from ownership of that stock. Each investor will have a different sense of what any given piece of news will mean for the future cash flows. As a result, it takes many such actors to effectively average out the impact of any given piece of information. The market also requires liquidity in order to ensure that the impact of new information is processed quickly. If new information is not processed quickly, then the market will be in a temporary state of inefficiency until the information is fully processed. A perfectly efficient market will not have such opportunities for arbitrage.
Yet in order for a market to have the necessary liquidity to be efficient, market participants must believe that arbitrage is possible -- that they can beat the market (Heakal, 2009). When market participants believe that they can beat the market, they will buy higher or sell lower than the current market price. It is this fluctuation in the price of an asset that gives liquidity to the market for that asset -- if everybody believed there was no way to "win" then trading volumes would be significantly lower than they are otherwise. Thus, the belief that there is some inefficiency in the market is what gives the market the liquidity it needs to become efficient.
Part of this comes from market participants who believe that they can "beat" the system -- that is to achieve higher than expected returns. Some of these participants believe their analysis to be superior to the collective analysis of all other participants (the current price) and this belief convinces them to enter the market. Other times, the market participant believes in entirely different schools of thought, such as technical analysis. Participants who subscribe to theories of market efficiency do not believe that the market can be beaten simply on the basis of technical analysis, but there are some who subscribe to technical analysis as a means of trading -- they may enter a perfectly efficient market under the assumption that their analysis is superior. This contrasts with the view of the efficient market hypothesis in which stock prices are a random walk, guided only by the emergence of new information and not by any set trading pattern.
Those who believe in EMH essentially dismiss technical analysts and other participants who believe that they have superior insight as irrational. This irrationality can help to move markets, however, and this is one of the two main ways that investors can benefit from efficient markets to maximize their wealth. The other way is to find instances where markets -- for whatever reason -- are not perfectly efficient. Irrational investors are often able to move markets. This is particularly true today, when stock trading programs make use of stop loss strategies and other tactics that are more technical than fundamental in nature. When irrational trades pull the price of an asset away from its "efficient" level, this creates an opportunity for rational investors to trade the stock. The result will be that when the irrationality exits the market, the price will return to the rational level and the trader will have profited from the irrational movement.
Because efficient market hypothesis relies on highly liquid markets, any market that is not highly liquid will leave opportunities for investing profitably. Again, this idea rests on the investor being able to determine what the normal, rational level of a stock should be. When new information is announced on an illiquid asset, the investor would gain first mover advantage by trading quickly when the price is more volatile. Over time, the market would reach its efficient level -- and this could be a matter of minutes -- and the investor will have gained.
These methods reflect the investor who believes him or herself to have superior analytical skills -- effectively dismissing EMH in the belief that some investors are irrational or that some markets are sufficiently illiquid for EMH to hold. If, however, one accepts that EMH always holds, this is also valuable for investors seeking to maximize their wealth. Under a market condition where EMH always holds, investors are unable to "beat" the market not only with technical analysis but also with fundamental analysis using either public or insider information. If the market is impossible to beat on a risk-adjusted basis, investors should adopt strategies that minimize the costs of investing while still capturing a risk-adjusted rate of return equivalent to that of the broad market.
The first implication of this is that the portfolio should be fully diversified. Full diversification -- adjusted to whatever risk level the investor is comfortable with -- will give the investor a portfolio that mimics risk-adjusted market returns. This is the best that the investor can hope for it strong-form EMH holds true. The second implication is…