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Market efficiency: know where youre headed and why

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Do you wish for your stocks and securities invested to tell you exactly what’s going on? Do you wish that just by looking at your stock prices you can determine what the level of market efficiency is? Well, for that you need to have a good understanding of market efficiency and what makes it tick!

 

What is market efficiency?

It may seem like a buzzword which all experts and analysts keep repeating. But market efficiency is actually quite a simple concept. Market efficiency basically refers to the ability of stock prices to reflect all current market information (LeBaron and Vaitilingam 1999 [online]), (Investor Home, nd [online]). There are various stages of market efficiency ranging from weak, semi strong and strong (Investopedia, nd [online]).

 

Can you beat the market?

You may be misled to believe that market efficiency means market perfection (Finance Professor, nd [online]) but it isn’t true. The basis of market efficiency hypothesis or EMH classifies market conditions into 3 types:

-          Weak: Where security prices are indicative of past prices, historical rates of return, block volume etc. (Kane and Marcus, nd [online]).

-          Semi strong: In this type of market efficiency the security prices are indicative of public available information. (Kane and Marcus, nd [online]). Most information available publicly will tend to suggest that the market efficiency is at its peak. However, you need to beware that all public information will not be automatically incorporated into the price (Kane and Marcus, nd[online]).

-          Strong: In this form of market efficiency all security prices indicate current public information. Thus in such a scenario, no particular trader can make money more than others as all information is freely available (Kane and Marcus, nd[online]) (LeBaron and Vaitilingam 1999[online]).

 

Stock market anomalies

Most investors, irrespective of the kind of market efficiency at present, are victims of widely believed perceptions. Example is like the ‘January effect’ (LeBaron and Vaitilingam 1999 [online]) which supposedly state that you can earn much higher returns in the very first month of the year. Or the ‘weekend effect’ (LeBaron and Vaitilingam 1999[online]) which states that you should refrain from purchasing stocks even if you find market efficiency either on a Friday afternoon or Monday morning. It’s because even if you find market efficiency, such stocks sell higher on these days and times. By believing in such anomalies you as an investor, risk investing only in such times and not in others. This way there will be many investors rushing in to invest, thus upsetting the prevalent market efficiency.

 

Types of market efficiency

There are 3 main types of market efficiency namely:

-          Operational: This implies the cost of securities on the exchange which the buyers and sellers have to pay for. The ideal situation is the implement trading on the lowest possible operational costs (Baisi and Kaijage, nd [online]).

-          Allocation: This type of market efficiency implies the optimal allocation of resources to bring out the maximum profits from your savings. Usually high growth segments such as electronics, biotechnology as well as pharmaceutical represent good areas where you can invest your funds (Baisi and Kaijage, nd [online]).

-          Pricing: This form of market efficiency refers to fluctuating or rising prices in securities as a response to some news or forecasts predicted (Baisi and Kaijage, nd [online]).

 

 

 

References:

 

Investopedia (nd) ‘Market Efficiency’, Available from http://www.investopedia.com/terms/ m/marketefficiency.asp

 

Investor Home (nd) ‘The Efficient Market Hypothesis & The Random Walk Theory’, Available from http://www.investorhome.com/emh.htm

 

Finance Professor (nd) ‘Market Efficiency’, Available from http://www.financeprofessor.com/488/ notes/market_efficiency.htm

 

Finance Professor (nd) ‘Efficient Market Hypothesis (EMH)’, Available from http://www.financeprofessor.com/488/notes/emh2.doc

 

LeBaron, D & Vaitilingam, R (1999) The Ultimate Investor, Capstone Publishing Ltd., London

 

Baisi, M & Kaijage, E (nd) ‘Session 1: Market Efficiency’, Financial Analysis Revised, 1:5 [online] (cited nd) Available from http://cbdd.wsu.edu/kewlcontent/cdoutput/ TR505r/page4.htm

 

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