Forms Of Market Efficiency

A major factor driving price movement is the arrival of new information. Efficiency is often understood as operational, but this theory is based on the concept of informational efficiency. Informational efficiency is the degree to which market prices are affected by new as well as existing information.

The Efficient Market theory states that the current stock prices impound all available information about the firm, and there is no way an individual(s) can consistently earn excess profits than the market return. This theory suggests that profiting from predicting price movements is a difficult and an unlikely event. It is impossible to outperform the market by picking undervalued stocks, as this theory states that there are no undervalued

Forms of Market Efficiency-

Depending on the level of available information, market efficiency may be broken down into three forms-

1. Strong Form-

This form of market efficiency asserts that the current prices reflect all existing information, both public and private (insider information). The weak form of market efficiency held that the prices do not reflect private or inside information, and so did the semi strong form. Inside information refers to important information about the plans or condition of a corporation that has not been released to the public, and can be used to gain unfair advantage. Insiders include the company’s directors and senior officers. The strong form states that insiders cannot gain from the private information they have access to. Strong form encompasses the weak and semi-strong form.

The simplest way of testing strong form efficiency is monitoring price changes close to an event. If the release of private or inside information does not result in price movement, then we assume that it is already reflected in the prices. For example, a merger or acquisition between two firms is known only by an ‘inner circle’ of lawyers, officers, firm managers before the press release. When such individuals make money by using this information, they are indulging in the illegal practice of insider

It seeks to combine cognitive psychological theory with conventional finance and economics to reason out as to why people make irrational financial decisions. According to behavioral finance, the three pillars of market efficiency do not hold well in reality.

1. It would be wrong to assume that investors are always rational. Diversification is required to generate good returns, but most investors do not achieve the degree of diversification that they should. The costs of brokerage and taxes incurred by investors are high. Behavioral finance is of the view that many investors are irrational.

2. Deviations from rationality cannot be random always. In fact, almost all investors believe that current performance is a mirror of future performance. These investors adjust quickly to new information and there is a bubble in the market. On the other hand, some conservative investors are slow and unwilling to adapt to new information. This results in slower adjustment of prices to new information, which is against the concept of market