Concept Of Market Efficiency And Its Importance Finance Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Eugene Fama is generally considered to be the father of the efficient market hypothesis from his work in 1970, I look at the evidence for and against this theory and go on to show how behavioural finance works against an efficient market with real life examples from the past decade showing the investors are not always rational.


The concept of market efficiency has roots that date back to Bachelier (1900) and over the past century many academics have interrogated this theory. The efficient market is thought by many to be essential to our economic system, Dimson and Mussavian (1998) wrote 'The concept of efficiency is central to finance' but in more recent years, this theory has been challenged by many academics.

I aim to look first at the concept of the efficient market hypothesis (EMH) and show its importance to our markets, following this I will also look at flaws to the hypothesis. The latter part of this essay will also look at more subjective topics such as Behavioural finance and what impact this has on efficient markets.

Market Efficiency

Firstly it is important to consider the definition of market efficiency. Market efficiency broadly means a market whereby all security prices always reflect all available information, as such, no individual or group is able to make an abnormal return on an investment as they are armed with the same information as any other investor. As new information becomes available it is acted upon immediately and investors will re-evaluate the expected return from the security, as Gitman (2009:343) pointed out 'Whenever investors find that the expected return is not equal to the required return (Å™ = r), a market price adjustment occurs'

Fama (1970) also discusses sufficient conditions within an efficient market; he notes that if a market were to have no transaction costs for the trade of securities, that if all information is available to all investors and that if all investors are rational (or will agree on the implications of information) then a market could be considered frictionless. His research goes on to say that a frictionless market is not what happens in practice and that any one of the three factors could be a source of market inefficiency. Fama is often considered to be the father of market efficiency and throughout the first part of this paper his work will be extensively quoted as the foundations of what we consider to be an efficient market.

There are three different forms of market efficiency as Fama (1970) points out, Weak Efficiency, Semi-strong efficiency and Strong efficiency, these three forms could otherwise be looked at as testing the efficient market hypothesis (EMH) against three different types of information and Fama tested the EMH against all three to varying degrees of success.

Weak efficiency is simply testing the EMH against historical prices and this was first possible with the introduction of computers, Kendall and Hill (1953) were the first to document such a study and after examining 19 stocks and commodities concluded 'in series of prices which are observed at fairly close intervals the random changes from one term to the next are so large as to swamp any systematic effect which may be present. The data behave almost like wandering series.' Following Kendall and Hill's work on the subject, the behaviour of the stocks that he observed became known as 'the random walk theory' and this theory offers no value in speculation of future prices suggesting it would be impossible from past trends alone for investors to create abnormal returns.

Semi Strong Efficiency is the second form of market efficiency and Fama (1970) describes this as 'tests, in which the concern is whether prices efficiently adjust to other information that is obviously publicly available', examples of public information could be mergers, profit warnings and other events.

Finally there is Strong form efficiency which is 'concerned with whether given investors or groups have monopolistic access to any information relevant for price formation' (Fama 1970) and as a result of having this information, whether investors are able to achieve abnormal returns. Strong form efficiency states that the market price of a security fully reflects both public and private information and as such, not even insider trading could provide abnormal returns.

In theory, if the market is always efficient in all three forms, it would be possible to look at the price of any security within the market and the price would accurately reflect all information, if new information emerges (either publicly or privately) then the price of the security will change to again represent the current market value. An efficient market is considered important because a security's value will always be represented in its share price, where a security is considered to be over or under valued then this information is available to the entire market, 'Therefore, if there are enough investors interested in the share, with enough money to buy and sell in large quantities, its market price will adjust to their collective beliefs'. (Barnes 2009:5)

Fama wrote his original paper on market efficiency in 1970 and, in 1991 returned with a sequel to his earlier work having spent the past 20 years studying and testing his earlier theory. I have spent some time above detailing Fama's original theory on Strong, Semi-strong and weak market efficiency because between 1970 and 1991 some of Fama's conclusions changed with the introduction of new research but importantly, with new technology that enabled him to better study the market. I think that it is important to review both of Fama's works on the subject to show how different his findings are after the test of time, and then how with the advances in technology since his 1991 paper will enable us to further be critical about the different forms of market efficiency.

If we broadly outline Fama's second paper (Fama:1991) we again look at the three forms of market efficiency, but this time called forecast power of past returns, (weak form) Event Studies (semi-strong form) and tests for private information. (Strong form)

Fama (1991) recognises in his paper that the strong form of market efficiency does not hold up to scrutiny and states 'We know that corporate insiders have private information that leads to abnormal returns (Jaffe (1974))'and these findings directly contradict the strong form of market efficiency.

Fama (1991) then looks at Semi-strong form efficiency (or event studies) and begins by saying 'The cleanest evidence on market-efficiency comes from event studies' and then goes on to say 'evidence tilts me toward the conclusion that prices adjust efficiently to firm-specific information'. Following 20 years of scrutiny, Fama firmly believes that Semi-strong form efficiency has held up. For an example of Semi-strong efficiency, we will briefly look at the stock price of Rolls Royce over the past month and how the market has reacted to new market information that could not have been predicted or foreseen. On November 4th 2010 at approximately 03:45 a Quantas aircraft was forced to return to Singapore shortly after takeoff due to an engine malfunction, ( the engine in question was manufactured by Rolls Royce and as shown in Appendix I, the price of Rolls Royce's stock sharply dropped as the LSE opened. This sudden drop shows the market reacting to a sudden and unforeseen event, investors suddenly saw that the stock was overvalued and subsequently offered their share of the company to the highest bidder, by large numbers of investors doing the same thing the market has been flooded with sellers and the equilibrium price has significantly lowered. The equilibrium price for Rolls Royce shares adjusted so quickly that two days after the incident, £1.2bn had been wiped off the company's value. (The Independent 2010)

Lastly Fama (1991) looks at Weak form efficiency, now called Return Predictability. He recognises there have been papers published about the predictability of stock returns but seems to down play a lot of these saying 'the results are similar to those in the early work, and somewhat lacking in drama'.

So how does the concept of market efficiency stand up against events other than those outlined in his paper? Well firstly let us look at Weak form efficiency and anomalies, more specifically, the day of the week effect. This effect, first documented by Kenneth French (1980) states that by studying daily changes in security prices it can be seen that 'the return for Monday was negative and lower than the average return for any other day' and goes on to further say that 'The persistently negative returns for Monday appear to be evidence of market inefficiency' and that traders could increase their returns by carefully timing their trades to delay buying securities from a Friday until a Monday, and not selling on Monday, instead selling on a Friday. This is a topic also looked at by Kenourgios and Samitas (2008) who found within the Athens stock market that 'The day of the week effect patterns in return and volatility might enable investors to take advantage of relatively regular market shifts by designing and implementing trading strategies'.

Lets now look at Semi Strong market inefficiency, firstly at the impact of financial analysts forecasts of earnings, 'The observed stock price reaction to an earnings announcement continues over several weeks or months after the announcement' (Givoly and Lakonishok:1979), Market efficiency states that the security price should change quickly to represent all new information but as Givoly and Lakonishok go on to point out 'This finding casts some doubt on the validity of the hypothesis of the semi-strong efficiency of the market'. This research suggests that it would in theory be possible to predict the movement of a security after the release of a forecast of earnings therefore demonstrating market inefficiency.

I believe when considering market inefficiency it is also important to review rationality. At the beginning of this topic we discussed how for a market to be efficient then at least the majority of traders within it must be rational, but there are instances recently where investors have been far from rational. If we look for example at the dot com bubble, the market added speculative value to any company with '.com' increasing its market value far beyond what a rational investor would value it at. Because of the speculation surround dot com companies many investors simply followed the craze and invested showing a less than rational approach instead basing investment decisions on 'hype', this thought process could be described as 'the presence of speculative rather than fundamental reasons for investing'. (Simon 2003) Martin Sewell (2007) also writes extensively about behavioural science and its impact on the efficient market hypothesis showing how investors are often, far from rational.


I have tried to present the evidence for, and against the efficient market hypothesis in an equal manner throughout this paper but do have some strong personal feelings about how the theory actually works in practice. Fama's original 1970 paper was, at the time hard to argue with but over the past forty years we have seen leaps forward in technological advancement that enable us to better study market movements such as computers, the internet and hand held calculators! Fama's theory relies on all investors being rational but this simply, is not always true. Advances in technology now mean that anyone can trade securities from home via their computers without any training or specialist knowledge and are even more likely to seek abnormal returns on their investments having seen how easy it can be from watching films! I still believe to an extent that the Semi-strong version of Fama's original work holds up to scrutiny except in cases where the majority of investors are already irrational (such as the dot com boom or the more recent credit crunch) where market prices of securities are more likely to be affected by investor confidence or beliefs than they are from public knowledge. As I mentioned earlier, Fama recognised that for an efficient market to function then the majority of investors must be rational, the truth is that this is not always the case.



RR stock.jpg