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 a
BF classic
+ see efficient,
efficient market hypothesis.

Markets live on information.

That food 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 states (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
threeideal conditions:

1) Standard goods (or assts) with enough of them available,

2) Enough players (without dominant ones),

3) Perfect information...

Although this is vividly debated,those conditions might be easier to
reach
 

* 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
     answer.


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

Consequence

  Strong
  form







The market price is always
optimum,

  It contains all private and
      public information.

It gives the  best

     

    risk / return balance,

No type of

analysis would
help make
extra money.




 

Semi-
strong

form



 

 



The market price:

reflect public
    information

But might be distorted by
    private
information.




Fundamental
      analysis
would 

help make extra
extra money.

Technical
      analysis might

help in some 
cases get a better
return, by spotting
price moves that
result from private
information.

  Weak
  form

 

 

Market prices take into
account
market information
(past prices, noise, investor
perceptions), even if they do
not match fundamental
information
(either public or
private).

Some extra

money  might be
made
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 for this "random walk" is that past prices, which are based
on past information, would rarely help to predict future ones.

Only future information, which occur at random, would play the main
role, once they get known.

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

Hard, or soft? Strong or weak?


Things become even more obscure when trying to define
"information"
in relation to efficient markets.


To say that prices contain all available information available can be admitted,
but in "hyper-strong" (or hyper-weak?) efficiency forms.

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, thus do
not affect immediately the markets !

Forms or degrees?

     Half full or half-empty ?

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, a
   
phenomenon that escapes past statistics and random 
   
laws, entails small or large, persistent or fickle,

market anomalies.

This makes that the RWH applies better:

* to some run of the mill / probability-friendly

market circumstances

* than in others, which are either more chaotic,

or more evolutional, or "stickier".

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, 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
a BF classic
+ see EMH,
efficiency, efficient market
hypothesis, information,
anomaly, 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 thus bring 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  market
robots grasping immediately how the news change the risk / returns
prospects.

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

Geniuses and robots might not see everything.

Other troublesome details on "anomalies" are seen in the "Efficient

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

Efficient market hypothesis (EMH)



Seen in many messages, as
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 by 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 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.

* 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
   
would 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 to do 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 BF group and, once there,
      1) click "messages", 2)
enter your query in "search archives".

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This page last update: 27/07/15  

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