Efficiency in any type of financial market is necessary for proper price formation. The financial markets are very wide, which is why covering many kinds of financial assets .
For a market to be efficient, two premises must be given:
- Market information must be available at no cost to the investor.
- The relevant information is reflected in the share price, bond, currency or interest rate.
Efficient market hypothesis
There are three types of efficiency in the markets according to the hypothesis of efficient markets:
- Weak efficiency:It is based on historical prices, which reflect all the information contained in past prices. So the past information (volume and prices) have no predictive power over the future price of the securities, because prices are independent from one period to another. In a context of weak market efficiency, risk-adjusted returns cannot be obtained using technical analysis .
- Semi-strong efficiency: It also incorporates public information. The values adjust quickly when the information is made public. So prices reflect all available public information. This would imply that risk adjusted returns could not be obtained through fundamental analysis .
- Strong efficiency:It is the efficiency that incorporates the previous two and private (internal) information. Prices not only reflect the historical and public information, but also all the information that can be obtained through the analysis of the company and the economy. This implies that no type of investor can access information relevant to prices, so that no one can constantly obtain excessive returns in the market.
Given the prohibition that exists in most markets on investing based on insider information, it would be unrealistic to think that markets are strong strong.
Many studies have shown that there is a weak form of efficiency. Past prices have no correlation with future prices. Prices turn out to be random. However, they do not support the fact that prices are right and therefore always correctly reflect intrinsic value. Therefore, there are also anomalies that reduce the credibility of weakly efficient markets.
The behavioral finance argue adaptive markets hypothesis.
The 6 lessons on market efficiency
- The markets have no memory. The price changes of the past do not reflect or have information about what will happen in the future. We have all heard many times of the famous phrase, ” Past returns do not guarantee future returns.”
- Rely on market prices. When the market is efficient, it means that the price collects all available information about the value of each asset.
- Learn to read the market before investing. There are many questions that must be solved to know what the market is in, and making a good analysis can draw conclusions in the future. What does a greater return mean? What projection does that company have? How is the interest rate curve? What signals does the market send us?
- There are no financial (accounting) illusions. There may be the case of creative accounting (which may or may not reflect changes in the price) or the case of split or against split of shares, in which case, there is no loss of power or increase thereof.
- Trust only yourself. A good investor would not pay another for something he can do.
- Elasticity of demand very high. Small changes in the changes in the price of an asset, involve large movements in the demand for it.