Market efficiency has important implications for the following disciplines of investing:
- Fundamental analysis is the practice of analyzing all the publicly available information about a security to forecast its future intrinsic value. If the markets are semi-strong efficient, the fundamental analysis should not yield excess returns. However, fundamental analysis is still important as it helps in analyzing any available information and its impact on security’s value. Highly skilled analysts though can still earn excess returns based on better insights into the same available information.
- Technical analysis is the practice of identifying patterns in a security’s historical pricing and trading volume trends and extrapolates it in future to earn excess returns. However, in weak form market efficiency, it would be impossible to earn abnormal returns as all historical information is already fully reflected in the price. But technical analysis is still important as it looks to exploit price inefficiencies and ultimately remove them (so it is impossible to earn excess returns consistently).
- Active vs. passive management: If markets are weak-form and semi-strong form efficient, it would be impossible for active managers to earn excess returns on public information. So passive management strategy should beat active management. Portfolio manager however still remain relevant as they help establish portfolios with definite objectives, and decide asset allocation and diversification as per the investor’s risk preference and investment objectives.
Check your concepts:
(47.7) Both technical analysis and fundamental analysis provide an excess risk-adjusted return in a market. The market is most likely:
(a) Weak-form efficient
(b) Weak-form inefficient
(c) Semi-strong form efficient
(47.8) In which of the following kinds of market, active management is most likely to be recommended?
(a) Semi-strong form efficient market
(b) Strong form inefficient market
(c) Semi-strong form inefficient market
Solutions:
(47.7) Correct Answer is B: Technical analysis can work only in a weak form inefficient market. Fundamental analysis can work only in a semi-strong form inefficient market. A semi-strong form inefficient market is also a weak form inefficient market.
(47.8) Correct Answer is C: The active management can only work if there is a possibility to earn excess return using fundamental or technical analysis. Fundamental analysis can work only in the semi-strong inefficient market. A strong form inefficient market may not be a semi-strong inefficient market.
