When people talk about market efficiency, they are talking about two different concepts. In one sense, the market can be said to be efficient if no one can consistently outperform the market based on skill. A somewhat weaker form would be more lenient when it comes to consistency. Some would be expected to outperform just based on random luck. If some outperform it, it can't be said for sure that it might not have been based on skill rather than just on luck.

The other sense of efficiency is that the market price is a good judge of the true fundamental value of a security. If this were the case the overall market would not be a volatile as it is. In an efficient market in which the market was indeed a good judge of fundamental values, the annual market return would not deviate much from the long-term required return on the market. All factors that influence value would be correctly evaluated and priced into the securities. But we are not good at forecasting the future. Let us say an unexpected recession hits the economy. We know we will have recessions. The unexpected nature of that recession might just be a matter of timing. But say it is an additional recession. It would mean a year of disappointing earnings, and one would expect the stock to decline by the amount of earnings shortfall. Now if there was a change in the assumption about the nature of the economy it might also require a change in risk premiums demanded. But this occurs much too frequently to blame that. If one does what Hetty Green did and buys in panics and sells in booms, one could do well. The problems come in that the market in this that there are too many factors in the future for any to forecast correctly and psychology influences markets in shorter time spans as do liquidity premiums. If the market deviates from efficient values in this sense, someone who could consistently forecast fundamental values could still fail to outperform because they cannot forecast how much the market will deviate from that true value. They might not have the staying power hold out until the market does return to that true fundamental value. Clearly this becomes more of a problem the shorter one's time horizon. In the very short time span of a trader, fundamental values might have little importance and other market factors might be dominant. Then only the first definition of market efficiency would have any relevance.

In sum, I ask the question are the markets efficiently smart or efficiently stupid and conclude the latter is more likely than the former.

Jonathan Bower writes: 

I'd say markets are efficient depending on your time frame and expected holding period. For every fundamental investor that sees a "fair" price, there are a dozen other participants who see a mispricing and vice versa.





Speak your mind


Resources & Links