Blog 1- The Importance of Stock Market Efficiency

Stock markets are growing. New markets are appearing in less developed countries to rival traditional stock markets, meaning stock markets are expanding all over the world. There has also been advances specifically in UK financial markets, caused by a number of things: increases in rapid changes in ICT; emergent of new types of trading, impacting on the modern market place; deregulation of financial markets; institutionalisation. One thing that is important for any stock market in any country is that it is efficient; no investors will be interested in getting involved in any stock market that is not efficient and fair.

          

What is meant by stock market efficiency? Put simply, in an efficient market, no trader is better off than any other. Neither technical nor fundamental analysis can yield risk-adjusted excess returns, only insider information can result in outsized risk-adjusted returns. No trader has the opportunity to gain a return on a share that is any bigger than a fair return for the risk associated with the share- apart from by chance. In an efficient market, the only way an investor can obtain better results is from buying riskier investments.

            

In an ideal world, all stock markets would be efficient and no investors would be able to predict market movements, but is this the case? Not entirely; a lot of studies suggest that prices do not move randomly like they should, or at least not fully.

        

    

Recently, the US stock market took a bad hit sending equities tumbling causing investors to stop putting their money into stocks. After a few weeks however, investors have returned cautiously to the stock market. Data shows that investors are beginning to allocate their money to buying stocks again even after a bad fall in the market. For me, investors collectively pulling out of the market and now collectively reinvesting their money, shows signs of an efficient market. The fact that all investors have done this at the same time due to the fall in the market shows that no investors have got any more information- or insider knowledge- than one another.

           

One theory about stock market is Kendall’s theory of ‘Random Walks’, saying that there should be no systematic link between one share price movement to the next; share prices at any time should reflect all known information. In my opinion I think this would be difficult to achieve in a market. For there to be NO links at all between share price movements investors would need to be investing in shares completely random and unrelated to each other. Otherwise, I think that share price movements from similar companies will inevitably influence each other.

            

This theory was then built upon by Fama, introducing three types of stock market efficiency: weak form efficiency, semi-strong efficiency and strong form efficiency. These are essentially what they say on the tin. A weak form efficiency means a market’s current share prices reflect all past movements- an efficient market does the opposite to this. A semi-strong efficiency means a market that reflects all historic and publicly available information and can react quickly to new information. Whereas a strong form efficiency means the share prices reflect ALL information and no one can make abnormal returns in the market.  

            

Looking at different theories and various news articles regarding stock markets and their efficiency, I think the importance of an efficient market is clear. However, actually being able to ensure that a stock market is fully efficient proves difficult. For me, it is interesting that each stock market in each country has a different set of companies with different prices of shares and different investors, meaning the efficiency from one country to the next can vary significantly. All stock markets may be monitored differently and some movements may need monitoring more than others; certainly emerging and less developed markets need more research. Whereas, a large developed stock market like the US already has a lot of research concentrated on it.