Category : Articles
Provide a brief review of the evidence concerning the information efficiency of the worlds major stock markets
Efficiency can be described as ???the ability to achieve desired result without wasted efforts or energy??? (Encarta dictionary, 2009).
In relation to financial markets, the measure of information efficiency can be assessed as being the speed with which security prices quickly and fully reflect all available information. Thus when information arises the news spreads very quickly and the effect is incorporated into the price of securities without delay. Investors are concerned with current or historic information since this influences commodity prices and so it follows that as more information becomes available the better informed the decision-making.
The implication for the investor is that he can rarely outperform the market whether through use of technical or fundamental analysis to achieve greater returns than those that could be obtained by holding a randomly selected portfolio of stocks at with comparable risk because the markets will have already reacted reflecting future developments in commodity prices. This is an important factor of financial markets and underpins market efficiency to the extent that the stability of major world markets relies upon it as a key constituent for building investor confidence and reducing the occurrence of market volatility.
Markets across the world are gaining greater efficiency as a result of improved information technology which allows huge amounts of information of varying degrees of complexities to be captured, disseminating and traded quickly on the markets. However there is a trade-off between time taken to receive the information and to have the information verified such that IT may inadvertently cause markets to be less efficient where price sensitive information is not acted on in a timely basis and thus profit opportunity is lost.
By contrast, Investopedia explains inefficient markets being evidenced where some securities are overpriced and others underpriced, which means investors can made abnormal returns/losses relative to their level of risk. Some investors have turned the gyrations of the financial markets into fortunes for instance Warren Buffet and John M Keynes whilst many other investors end up like Isaac Newton who after losing a bundle of stock exclaimed ???I can calculate the motions of the heavenly bodies, but not the madness of people??? (Larry MacDonald, 1998)
Evidence would suggest that markets cannot be entirely efficient or inefficient but a mixture seen as a mixture of both since if all participants in the market believed it to be efficient no investor would seek to make abnormal profits.
Secondly, provide a critical assessment as to whether or not the recent volatility in share prices and similar periods of extreme volatility (e.g. during the “dot com bubble”) provide evidence of the inefficiency of stock markets in valuing the companies quoted in their exchanges.
The efficient market hypothesis is associated with random walk theory whereby share prices and all subsequent changes represent random departure from previous prices. Thus if information flows unimpeded and is immediately reflected in stock prices then tomorrow??™s price will reflect only tomorrow??™s news. However news in unpredictable and thus the resulting price changes are unpredictable and random, altering as new information becomes available. Essentially investors have access to all relevant information about a company and will therefore act upon the information in a rational manner.
There are number of influences that trigger price volatility often leading to the markets making egregious mistakes in valuing company shares. Markets are influenced by investor sentiment, fear, greed and speculation.
Behavioural finance attempts to explain the market implications of the psychological factors behind decisions and suggests that irrational investor behaviour may significantly affect share price movement. Individuals see a stock price rising/falling and are drawn/flee the market in a ???bandwagon effect??? (B Malkiel, 2003)
For instance the stock market crash in 1987, markets around the world fell significantly caused by short-run overreaction to events. Equally, Shiller (2000) describes the rise in US stock market during the late 1990s as the result of psychological contagion leading to irrational exuberance.
Political events may cause significant share price movement on world markets such as wars, terrorism, and unstable government. Notably the previous sharpest one day fall prior to 1987 crash was on March 1, 1974 after Labour indecisive election victory when share fell 7.1%.
During the dot.com bubble period investors responded to daring business opportunities by throwing lots of money at it and the market rose. Unfortunately, the growth in the tech industry proved to be illusionary and the markets immediately tumbled by way of correction.
Share prices and their individual volatility is also linked to investor confidence in the company??™s future prospects both in terms of dividend streams and capital growth and thus investor speculation plays a major part in share valuation as do marketability and liquidity of shares.
Other anomalies of market irrationality include the season of the month effect, day of the week effect such that share prices might tend to rise or fall at a particular time of the year, week or day.
In conclusion it is my opinion that markets are far more efficient at valuing stock prices as they do not allow big winners unless big bets are placed on the market.