Security prices move up or down as they factor in new information related to the security. For e.g. if the car sales in a country slow down, it is bound to impact the stock prices of the automotive industry. Market efficiency is a measure of the degree to which all the publicly available information has been factored in by the security prices. Higher the market efficiency, lower the pricing discrepancy and tougher it is to make outsized returns from price appreciation. The reverse also holds true. Hence, market efficiency is an important aspect for investment managers.
In a highly efficient market pricing anomalies will be few and hence it may be a better option to buy and hold a broader index than individual securities to earn better risk-adjusted returns. This is known as a passive investment strategy. Active investment strategy generally looks for pricing anomalies i.e. information not getting fully reflected in prices in inefficient markets. In such a strategy, it is better to invest in individual securities that can give abnormal returns than broader index. Between these two strategies, passive style is cheaper option as active strategy involves higher costs (seeking information, transaction costs etc)
Two key important points on efficient markets: a) short time frame in which information gets reflected in the security price. While there is not set timeline, the time allowed is at least as long as it takes for traders to execute one trade. b) Information should be unexpected. In an efficient market, expected information should have already been factored in (and will not impact the prices), and it is the surprise element that needs to be processed by the investors.
The key advantage of market efficiency is that it promotes appropriate allocation of resources. Since the prices reflect all the available information, funds are channeled to companies that put capital to best use.
Check your concepts:
(47.1) The prices of securities in a market do not reflect all the available information. Which kind of investment strategy is most suitable for the market?
(a) Active investment strategy
(b) Passive investment strategy
(c) Both active investment and passive investment strategy
(47.2) Company Zoltan Chemicals had guided its full-year revenues at $150m and EPS of $1.20. The market had priced in the guidance given by the company. The revenue and EPS for the company for the last year were $110 million and $0.95 respectively. The actual results came in at $140 million revenues and EPS of $1.10. How is the market price likely to behave in an efficient market (all else being equal)?
(a) Increase in the market price
(b) Decrease in the market price
(c) No change in the market price
Solutions:
(47.1) Correct Answer is A: An active investment strategy works best when the market is inefficient i.e. when all the available information is not priced in the market.
(47.2) Correct Answer is B: The actual results came out to be lower than the expectations from the market. Hence, there will be a decrease in the market price of the security.
