Efficient Markets Investors do not like risk and they must be compensated for taking on

Efficient Markets Investors do not like risk and they must be compensated for taking on

risk—the larger the risk, the more the compensation. But can investors earn a return on securities beyond that necessary to compensate them for the risk? In other words, can investors earn an abnormal profit on the secondary markets? Can they beat the market? The answer is “maybe.”

An efficient market is a market in which asset prices rapidly reflect all available information, and the securities markets in the United States are typically thought of as being highly efficient. This means that all available information is already impounded in a security’s price, so investors should expect to earn a return necessary to compensate them for their opportunity cost, anticipated inflation, and risk. That would seem to preclude abnormal profits. But according to at least one theory, there are several levels of efficiency: weak form efficient, semi-strong form efficient, and strong form efficient. 4

3 For example, the Commodity Futures Trading Commission (CFTC) is a regula- tory body established by Congress to approve new types of futures contracts and

to establish trading rules for futures exchanges. 4 Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical

Work,” Journal of Finance, Volume 25, Number 2 (May 1970), pp. 383–417.

Securities and Markets

In the weak form of market efficiency, current securities prices reflect all past prices and price movements. In other words, all worth- while information about previous prices of the stock has been used to determine today’s price; the investor cannot use that same information to predict tomorrow’s price and still earn abnormal profits. 5

Empirical evidence shows that the securities markets are at least weak-form efficient. In other words, you cannot beat the market by using information on past securities prices.

In the semi-strong form of market efficiency, the current market prices of securities reflect all publicly-available information. So if you trade on the basis of publicly-available information, you cannot earn abnormal profits. This does not mean that prices change instanta- neously to reflect new information, but rather that information is impounded rapidly into the prices of securities.

Empirical evidence supports the idea that U.S. securities markets are semi-strong form efficient. This, in turn, implies that careful analysis of securities and issuing firms cannot produce abnormal profits. 6

In the strong form of market efficiency, stock prices reflect all public and private information. In other words, the market (which includes all investors) knows everything about all securities, including information that has not been released to the public.

The strong form implies that you cannot make abnormal profits from trading on inside information, where inside information is infor- mation that is not yet public. 7 This form of market efficiency is not sup- ported by the evidence. In fact, we know from recent events that the opposite is true; gains are available from inside information.

As pointed out above, U.S. securities markets are essentially semi- strong efficient. This means that investors can, for the most part, expect securities to be fairly priced. So when a firm issues new securities, it should expect investors to pay a price for those shares that reflects their value. This also means that if new information about the firm is revealed

5 This doesn’t mean that trying it once may not prove fruitful. What it does mean is that, over the long run, you cannot earn abnormal profits from reading charts of past

prices and predicting future prices from these charts. Do investors actually try this? Well, there are financial services in business today that perform analysis of stock prices (called technical analysis), so someone out there is doing it.

6 Does this mean that financial analysis is worthless? No. We still need financial anal- ysis to help us sort out risk and expected return so that we can properly manage our

investments. 7 There is no exact definition of “inside information” in law. Laws pertaining to in-

sider trading remain a gray area, subject to clarification mainly through judicial in- terpretation.

FOUNDATIONS

to the public (for example, concerning a new product), the price of the stock should change to reflect that new information.

But a semi-strong efficient market also means that an investor can make abnormal profits through trading using information not known to the public. Such trading tends to distort the prices of affected securities and thus to harm at least some investors. For that reason, and because investigators found evidence of such trading during the corporate merger mania of the 1980s, existing anti-insider trading legislation has recently been strengthened and reinforced. Strengthening such legisla- tion tends to ensure the fairness of securities prices.

In essence, it is illegal for any person with an agency relationship to a firm to benefit financially through non-public information obtained as a result of that relationship. This does not mean that executives of a corpora- tion cannot buy and sell shares of the firm. Trading by insiders (members of the board of directors and the employees of the firm) is legal if it is not motivated by the use of non-public information. What it does mean is that insiders cannot use inside information to make their personal investment decisions; doing so would be illegal insider trading. As another example, an investment banker who is negotiating the merger of two corporations cannot legally purchase the stock of those corporations knowing that the market prices will rise when news of the merger is made public.