Market Efficiency

Topics: Mutual fund, Stock market, Hedge fund Pages: 5 (1542 words) Published: March 5, 2014

Market Efficiency Extended Essay

In this extended essay I will address a number of key issues in relation to market efficiency. I will define market efficiency and describe the three different forms of market efficiency which consist of; weak-form efficiency, semi-strong form and strong-form efficiency. I will also outline the characteristics of market efficiency. I will then define what a mutual fund is and compare and contrast an open-ended mutual and a closed-ended mutual fund. I will also then give my opinion on why I don’t think that mutual funds consistently out-perform the market.

Market efficiency was developed in 1970 by economist Eugene Fama. He came up with the theory efficient market hypothesis which states that it is not possible for an investor to outperform the market because all available information is already built into all stock prices. Market efficiency is basically the degree to which stock prices reflect all the available and relevant information.

A perfectly efficient market means that the prices reflect all information knowable and relevant. A perfectly efficient market means that there are no undervalued or overvalued securities. It doesn’t matter what the pricing structure of the market is, the market is priced perfectly in terms of that structure.

An efficient market is defined by available and accurate information about the securities and their prices. The efficient market hypothesis is based on the idea that every investor has all of the information about the securities available, the price demand as well as all of the other information which can be regarded as relevant. This relevant information may include past market behaviour or the performance of the particular company who are issuing the stock. The idea of an efficient market is that the more efficient it is then the more informed the decisions are of the investors.

A market can be described as a place for investors to trade securities. An efficient market is one where prices change rapidly in response to the changes in demand and supply; therefore prices are fair at any given time.

Fama defined an efficient market as “one in which prices always fully reflect available information”. The efficient-market hypothesis theory states that in any given time, the prices of the market already reflect all known information and also change fast to reflect new information. Therefore, nobody could outperform the market by using the same information that is already available, except through pot luck.

Fama came up with three different levels of market efficiency: Weak-form efficiency:
Prices of the securities instantly and fully reflect all information of the past prices. This basically means that future price cannot be predicted by using past prices. Past data on stock prices are of no use in predicting future stock prices. Everything happens randomly. A “buy-and-hold” strategy is best used in this case. All historical information is reflected in the stock price.

Semi-strong form efficiency:
Prices fully reflect all of the available information to the public. This includes information in the firms accounting reports, the reports of competing firms, any information relating to the economy and any other information available to the public in terms of the valuation of the firm. This basically means that only somebody with additional inside information could have an advantage in this market. Any price abnormalities are quickly found out and the market adjusts. All public available information is reflected in the stock price.

Strong-form efficiency:
Prices fully reflect all of the public and inside information available. This basically means that nobody could have an advantage in the market in terms of predicting prices because there is no data that would provide any additional...

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Schlesinger, J. (2012). You can 't beat the market, so stop trying. Available: http://articles.chicagotribune.com/2012-07-04/business/sns-201207040000--tms--retiresmctnrs-a20120704-20120704_1_fund-managers-low-cost-index-individual-stocks. Last accessed 17th Dec 2013
Pratt, J. (2013). Study: Only 24% of active mutual fund managers outperform the market index. Available: http://www.nerdwallet.com/blog/investing/2013/active-mutual-fund-managers-beat-market-index/ Last accessed 16th Dec 2013
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