Understanding How Information is Reflected in Asset Prices
An efficient market is one where security prices fully reflect all available information. This means that prices adjust quickly and accurately to new information, making it difficult to consistently earn "abnormal returns" (returns greater than what the risk level of the investment justifies).
The current price at which an asset is trading.
The true, underlying value of an asset based on its expected future cash flows. This must be estimated and is not known with certainty.
In a perfectly efficient market:
Market Value = Intrinsic Value
In inefficient markets, opportunities arise when these two values diverge.
The Efficient Market Hypothesis (EMH) is categorized into three forms, each defined by the type of information that is assumed to be reflected in prices.
Prices reflect all past market data (e.g., historical prices and trading volumes).
Prices reflect all publicly available information (past data + public info like news, earnings reports).
Prices reflect all information—public and private (insider information).
No market is perfectly efficient. Efficiency is a spectrum and is influenced by several factors:
More traders and analysts lead to greater efficiency.
Greater transparency and access to information increase efficiency.
High transaction costs, restrictions on short selling, and execution delays can hinder arbitrage and reduce efficiency.
Market anomalies are patterns in security returns that seem to contradict the Efficient Market Hypothesis. For an anomaly to be a true violation of the EMH, it must be persistent over time and profitable after accounting for all costs and risks.
Funds often trade at a price below their Net Asset Value (NAV).
Stock prices adjust rapidly to earnings announcements, making it difficult to profit.
IPOs are often underpriced, leading to a first-day price jump, but tend to underperform long-term.
Behavioral finance challenges the EMH's assumption of rational investors. It argues that while markets as a whole may be efficient, individual investors are not always rational and are subject to cognitive biases that can lead to mispricing and anomalies.
Investors feel the pain of a loss more strongly than the pleasure of an equivalent gain, leading them to hold on to losing investments too long.
Following the crowd and ignoring one's own analysis, which can amplify market bubbles and crashes.
Overestimating the accuracy of one's own beliefs and forecasts, leading to poor diversification and excessive risk-taking.
Traders imitating the actions of others, assuming they are better informed. This can spread both rational and irrational behavior through the market.
Includes representativeness, mental accounting, conservatism, and narrow framing, all of which can lead to irrational financial decisions.