3 Ways an Efficient Market Presents Investment Opportunities

Source: Thinkstock

Source: Thinkstock

In financial studies and analyses, one of the great debates is whether or not the market is efficient. That is, whether market prices reflect all relevant information and whether or not an investor can continually “beat the market.” In Eugene Fama’s 1970 work on Efficient Capital Markets, he writes “a market in which … firms can choose among securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information … is called efficient.”

Weak form efficiency focuses primarily on historical prices, and how past data, charts, and pricing information alone cannot be used to determine current security prices. Semi-strong form is the most well-known form as it is the basis behind most market efficiency research. Semi-strong form tests whether the market is efficient based on past information and also, current public information like press releases, announcements, or annual reports. Finally, strong form efficiency extends this concept to include all information — public and private. Even given insider or privy information, the efficient market theory should stand under strong form, with a few exceptions.

Efficient market theory (EMT) mathematical models show that an efficient market does not render all stock prices and values equal at every point in time. The EMT says any deviations between price and value are random, and it is equally likely that an investor will suffer a loss as it is for him to earn a gain.

But what about all of the reported anomalies? The January effect, low P/E ratios, and the small firm effect should not hold under the efficient market theory. The EMT says anomalies are possible, but such cases should be random and unbiased in nature. For this reason, among others, many argue the validity of the EMT.

Should you assume an efficient market? The consensus seems to be that the EMT has many practical applications, and has been the framework for a plethora of additional research, but the EMT does not completely describe the market as a whole. If stocks truly take random walks, could anyone ever earn any money?