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Market Efficiency Theory

The theory of stock market efficiency is a topic that will be useful to both active and passive investors. The speculators, which are using technical analysis in their activities, would be particularly interested.

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Efficiency theory provides an eternal reason for discussion in the scientific and financial community. On the one hand stay scientists, on the other - speculators and active stock market investors. However, the pundits claim that the market is efficient and it is stupid to try to surpass it, while the latter try to prove quite the opposite. Which side is right? Let's figure it out.

The main question that the theory of efficiency is trying to answer is how efficient the market is, and also to find out if there are ways to get profitability that exceeds market indicators.

There are many definitions of market efficiency, with the only difference being that the term is viewed from different angles, emphasizing one or another of its aspects.

General definition

Market efficiency - all participants have free and equal access to information with respect to various investment opportunities, thereby market participants equally can use the available information to identify the reasons that have impact on the target security versus its market value, as well as correctly predict its further dynamics.

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Quick adaptation to information

Any new information is instantly taken into account in the market value of securities, therefore, from this point of view, market efficiency is a quick adaptation to new information.

True value

The market value of the shares is determined by market participants through their assessment of the investment true value.

Key Assumptions of Market Efficiency Theory

Theory of market efficiency developing needed the following assumptions usage:

  • Information is distributed instantly, without any obstacles, it is free and available to all market participants at the same time.
  • There are no commission expenses, taxes, or other factors that may interfere with market participants during transactions concluding;
  • An individual participant in the securities market (individual or legal entity) cannot affect the overall price level in this market.
  • All market participants act to maximize their own benefits

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Everyone knows that there is nothing ideal in the real world, and the theory of market efficiency is not an exception. The assumptions on which the theory is based cannot be fully realized in the real world. Information is not always available and free, and banal interruptions in communication are quite possible. The conclusion of transactions on the stock exchange is always associated with commission costs, and we must not forget about the tax burden. Market participants really strive for maximum benefit, but sometimes they act irrationally, which leads to disappointing consequences, the human element is never dismissed.

Moreover, the assumptions of the theory of market efficiency given above can be said to be closer to reality. There are also assumptions of the theory that are more detached from reality, which greatly complicate its evidence:

Investor expectations regarding future market prospects are uniform.

  • All investors have the same investment horizon.
  • The number of assets available for purchase is fixed, as well as infinitely divisible, which allows you to invest with surgical accuracy
  • Investors can borrow or lend capital at a risk-free (0%) rate.
  • The stock market is in a state of balance (equilibrium), the value of any asset reflects its inherent risk.

Well, actually you admit yourself. Investors expectations with respect to any asset are never uniform, each investor has his own investment horizon (which is in agreement with his personal investment plan). The amount of assets in the market cannot be fixed and even more so infinitely divisible. There is no question of a 0% credit rate, even in countries where the key rate is negative, let alone developing countries. And finally, the value of an asset sometimes does not accurately reflect the inherent risk of that asset.

Three forms of market efficiency

In order to make it easier to put the theory to the test, 3 forms of market efficiency were introduced: weak, moderate, strong. Each form evaluates market performance in different ways. But they have one thing in common - a comprehensive review and proof of the inappropriateness of using analysis methods that will lead to investment returns that exceed market average indicators. Moreover, the analysis is from the point of view of information efficiency.

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  • avatar-2484
    Kelly
    • #

    Very interesting article, thank you for sharing. Very useful. Currently, I prefer passive investments, but I would like to switch to the active one.


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