What does market efficiency mean?

FIN 352 – Professor Dow

What do we mean by “efficiency”?

Common meaning: Markets always get things right.

Economic: Markets allocate resources to their most efficient uses.

Financial: Markets are informationally efficient.

Efficient Market Hypothesis

Asset prices fully incorporate all available information.

What does all mean? What does fully mean?

Four interrelated questions about information efficiency

How quickly is new information incorporated?

What information is incorporated?

Is information incorporated correctly?

Does extraneous information matter?

Boeing Example

The government announces that Boeing will get a contract to build tankers.

How quickly does this news get reflected in Boeing’s stock price?

Can you be the first to the market and buy Boeing stock before the price increases?

Boeing, cont’d.

Say that the government announces some information about the contract, provides other information in reports and keeps some other information private.

What information do people pay attention to?

Can you gain by using information that is available and that others ignore?

Boeing, cont’d.

The government releases information about how many planes they intend to buy and at what price.

Do investors correctly forecast how that will affect Boeing’s profitability and price?

Can you do a better job in forecasting?

Boeing, cont’d.

If there wasn’t any new information about Boeing profitability, might investors still change their opinion about Boeing stock?

Could you take advantage of this behavior?

Why does it matter?

If markets get the price right, no point in trying to beat the market

Why markets should be efficient

Incentives to make money

Paradox: impossibility of perfectly efficient markets.

Why markets might not be efficient

Psychological biases: behavioral finance.

“Markets can remain irrational longer than you can remain solvent”

How to test?

Do investors beat the market in practice? Luck vs. Skill.

Predictability of stock returns?

Details of tests in next lecture.

What does the evidence say? The market is roughly efficient – stock

prices are hard to predict.

The market is not perfectly efficient.

More efficient with some kinds of information than others. Quickly incorporates new information. Better at comparing companies rather than

determining overall levels. Irrational exuberance.

Implications for Investors

If you think markets are inefficient,

you should be able to explain what the inefficiency is and why you can take advantage of it.

Otherwise, passive investing is the better strategy.