Behavioral finance FAQ / Glossary (Efficient market)

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Dates of related message(s) in the Behavioral-Finance group (*):

Year/month, d: developed / discussed, i: incidental

(market) Efficiency

Seen in many messages, as it is a BF classic

+ see efficient, efficient market hypothesis.

Markets live on information.

A food that is supposed to make them healthy and efficient.

But is it a balanced diet?

Definition

A market is said to work efficiently:

when the prices of its traded goods or assets reflect perfectly

and immediately all known information .

Market efficiency would mean also that:

In a capital asset

market

 

(See "efficient" and

"efficient market

hypothesis").

Returns and risks

Are consistent with currently known information,

thanks to adequate market prices.

In macro-economics

Market prices allow for the best allocation of resources.

Does market efficiency exist?

Who believes in perfection?

The standard theory says (see "efficient market hypothesis") that financial markets are efficient when

they are structured and organized in a way that allows a "perfect competition" which result is

a "fair price" (efficient price).

Efficient hand?

The Capital asset market efficiency theory / hypothesis applies to finance, by adding

probabilistic mathematics (see stochastic, random walk...),

to a more traditional and general economic theory that was illustrated

by the "invisible hand" metaphor coined by Adam Smith.

It sustains that free markets allow that nothing, until the last crumb, is wasted,

every information is used and digested in the best way, and economic goodies are allocated soundly.

We will not develop here this economic theory about perfectly competitive markets.

Let us just say that it states that such a market should meet various ideal conditions:

1) Standard goods with enough of them available,

2) Enough players (without dominant ones),

3) Perfect information...

Those conditions might be easier to reach - but even this can be vividly debated -

* in large financial markets, commodity markets and currency markets

* than in the everyday consumption of goods and services.

In financial markets - stock markets among others - the double question, which divides observers, is:

1) In the real world, are there asset markets that fit that theoretical concept?

The "efficient market hypothesis" article (see below) tries to give approaches to answer that question.

2) What are the possible forms (and degrees) of efficiency,

They are described in the section below.

Types and degrees of market efficiency

Are all information equal?

Capital markets theoreticians see a range of possibilities about pricing / return efficiency, that they call "forms of efficiency"

Form

Definition

Consequences

Strong

form

 

The market price is always the best one, as:

It gives the best risk / return

balance,

It expresses all private and public information.

No type of analysis

would help to make extra money.

 

 

Semi-

strong

form

 

 

The market price:

reflect public information

But might be distorted by private

information.

Fundamental analysis would not

help make extra money.

Technical analysis might help in

some cases to get a better return,

spotting price moves that could

result from private information.

Weak

form

 

 

Market prices take into account

endogenous market information

(past prices, noise, investor perceptions), even

if they do not match fundamental information

(either public or private information).

There might be some extra money

to make by using fundamental

analysis.

 

Those three forms of efficiency have in common that, in efficient markets,

prices would normally move at random (*): see RWH.

The rationale is that past prices, which are based on past information, would rarely help to predict future ones.

Only future information would play the main role, once they get known on their evolution.

(*) Of course, it should not be inferred, conversely, that when there is randomness there is always efficiency.

Hard, or soft? Strong or weak?

Things become even more obscure when we try to define "information"

in relation to efficient markets.

To say that prices contain all available information available can be admitted,

but in a "hyper-strong" (or hyper-weak?) efficiency form.

Here, the enlarged definition would be that those prices contain the whole bunch of information,

which is not easy to untangle, about:

As well "hard facts"...

related to the goods, services and

assets available on the market,

...as "soft facts"

such as the current mood

of the buyer and seller crowd.

For financial assets, relevant information are those objectively liable to change risk / return anticipations.

Non relevant information are called "noise" (see that word).

But those noise guide some traders!

Not too salient information but that might have a big impact on prospects are called "weak signals"

(see that word). But those signals might be neglected by traders / investors!

Forms or degrees?

If we use a fuzzier / non binary / non Aristotelian concept, there is a variable "degree of efficiency" (see "anomaly").

Market players pick and choose - sometimes wisely, sometimes not - among the various information,

either public or private, either exogenous (economic fundamentals) or endogenous (investor behaviors).

Such a variable attitude towards information, which escapes past statistics and

random laws, entails small or large, persistent or fickle, market anomalies.

 

This makes that the RWH applies better:

* in some run of the mill / probability-friendly

market circumstances

* than in others that are either more chaotic ,

or more evolutional, or more "sticky".

Efficiency, time and assets

Short or long? Micro or macro?

Some debates, which might have incidences in money management styles, are also taking places about:

Macro efficiency (the whole market) vs. micro efficiency (individual stocks or assets) ....

Short term vs. long term market efficiency

Long term market efficiency is the idea that if you wait long enough, prices will be all right ...one day....

This is akin to "reversion to the mean", if we suppose that the mean matches the "fair value" (see that term).

Is long term efficiency a reality?

In the short or medium term, which could last for months or years, market

prices may stay above or below the fair price, in a small or a big way.

But one day or another they would hit exactly the center of the target.

And maybe the next day they will diverge again, in a small or big way.

Long term efficiency is a reality ...but a fuzzy, an approximate one.

 

Dates of related message(s) in the Behavioral-Finance group (*):

Year/month, d: developed / discussed, i: incidental

images/pi-arrig.gif Efficient (market, price)

Seen in many messages, as it is a BF classic

+ see EMH, efficiency, efficient market hypothesis,

anomaly, information, value, utility + bfdef

Grapes give wine, information give prices.

Now comes the tasting...

Definition:

An efficient market - as detailed above in "(market) efficiency" - is a market in which prices are supposed to:

Express all known information,

Reflect a good monetary risk / reward balance

and to bring therefore a sound allocation of resources,

Reach and keep a stable equilibrium

that changes only when a relevant new information is known.

The market's pricing of an item, reached through this equilibrium, is thus supposed to be:

The exact and full reflection of all available information.

Every time a new and unexpected relevant information (surprise) reaches the market, this price is supposed

to change immediately and correctly.

Thus, the best estimate of its "value" (see that word).

For example, in a financial market, an asset price is supposed to reflect exactly

the asset's projected returns and risks

Weaknesses of the concept

Sand grains in the gears.

The efficient market concept has several weaknesses.

It considers irrelevant and without effects on markets all other motivations than monetary returns and risks.

(economic "utility", see that word).

It rests on the idea of instant price adjustment when new relevant

information hit the market in a random way,

That would be thanks to an army of brilliant arbitrageurs and sophisticated market robots

grasping immediately how the news change the risk / returns prospects.

This is forgetting about delays, underreaction, overreaction...

Geniuses and robots might not see everything.

Other troublesome details on "anomalies" are seen in the

"Efficient market hypothesis EMH)" article below ("Does this hypothesis fit market realities" chapter).

Efficient market hypothesis (EMH)

Seen in many messages, as it is a BF classic

+ see efficient / efficiency, behavioral finance,

CAPM, fundamental value + bfdef

Hypothesizing financial markets as the Grail of Perfection.

Definition: The EMH / efficient market hypothesis states that

large and free financial markets are efficient (see efficient / efficiency).

This now famous theory was proposed in 1965 by Eugene Fama and Kenneth French.

According to it, there is only one possible market price

that reflects a perfect balance taking into account all information.

Thus this theory considers that there is no arbitrage opportunity,

as any return anomaly - or any newly known event - is supposed to be immediately

taken into account in market prices.

There would been no crumbs left on the balcony, the pigeons would have immediately eaten them.

Assumptions about the causes and consequences

Money-wise investors?

The assumptions in the efficient market hypothesis are that,

Not only markets are efficiently organized

(with enough liquidity and transparency, as defined in the efficiency article),

But also that investors, or at least the dominant ones (*),

1) Are rational,  2) Are fully informed and reactive,  3) Maximize their expected utility

(*) Dominant players are those with enough financial power that would act as rational arbitrageurs

and would correct the anomalies created by irrational players.

These conditions would make assets prices reflect their "fundamental value",

by taking wisely into account the return prospects and risks.

Another stated consequence of this thesis is that assets prices would move at random

(see RWH / random walk hypothesis) as unexpected relevant information happen also at random.

Does this hypothesis fit market realities? What about anomalies?

Disobedient market?

Some arguments against the efficient market theory are related to market realities.

If stocks were priced perfectly by the market:

There would be very few market activity, as there will be few reasons to buy or sell.

Also, bear and bull markets would not exist,

Prices would adjust immediately to news that change prospects, instead of following

* an (either gradual or exuberant) uptrend

* or an (either slow or panicky) downtrend.

See also the "efficient" article about the weaknesses of the concept.

SEMH / Semi-efficient market hypothesis?

Here comes BF, which buys only a part of the EMH story.

Behavioral finance (see that word), which studies mispricing and its causes, refutes

- not fully but in some proportion - the efficiency hypothesis.

Behavioral finance claims that investor biases are market

  bugs that can persist, and do not always average out.

This is because some biases are common to many people,

and also because mimicry / contamination is at work between investors.

BF does not say that markets are inefficient. This would be a

reductive generalization, the same than saying markets are efficient.

But it admits the existence of only a "degree of market

efficiency" (see efficiency, fuzzy logic), with a cursor that varies

with the types of markets  and the states of affairs.

In other words it sees a loose and variable relation between

market prices and the economic world.

Paradoxically, the EMH, however flawed, keeps being the practical reference to detect those deviations,

called "biases" or "anomalies" or more simply "effects".

The question is: are those discrepancies from this standard theory related to

* biased realities (flaws in market organization...)

* or flaws in the theory?

It seems that, whatever the "practical" causes, those anomalies signal limitations of

a theory that cannot encompass all realities.

Also, when it dissects the RWH - Random Walk Hypothesis, which is usually associated with the EMH,

Behavioral finance states that:

Random evolutions do not prove that assets are efficiently priced,

There are cases in which prices don't behave fully at random ( "persistence" phenomena...).

Utilization of the EMH

Aging top models

Most classical financial models (see model), created in the last decades of the 20th century,

have been based on the efficient market hypothesis.

The earliest and most famous ones are the CAPM and the Black and Scholes option theory.

Those models are still utilized as a basic approach.

They are now sometimes complemented by other ones, taking into account large and persistent deviations

between those ideal models and realities.

Maybe the most serious reproach that can be made to the EMH is that

A widespread worship for that theory, seen as a divine or

natural law, made monetary and financial authorities deny the

blatantly conspicuous bubble that led to the subprime crisis.

That belief prevented them to take steps to stop the madness

before it backfired.

(*) To find those messages: reach that Behavioral-Finance group and, once you are there, 1) click "messages", 2) enter your query in "search archives".

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