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Efficient Market
“I'd be a bum in the street with a tin cup if the markets were efficient.”
- Warren Buffett
Foreword
Market efficiency is one of the most controversial topics in finance. On one side
of the debate are most academics and on the other side are many practitioners
whose wealth depends on investors trading. (Some say we need to get out
more!)
The debate has gone full circle: from the market can not be efficient to “well it is
efficient, but there are some chinks in the armor of efficiency.” Market efficiency
is the idea that the market price is right. Thus efficiency comes about as the
result of competition. The many participants are all trying to be the first to get
information that will effect security prices. By trading on this information, the price
will quickly reflect the information. For example, suppose you find out some good
news about a firm. You go and buy the stock. This action drives the price up. If it
gets too high you will sell. This will keep the price at its correct level.
Information and competition are the underlying principles guiding market
efficiency. Think of an asset price being based off of forecasts of future
conditions. (example: the future supply, demand, competition, etc.) These
forecasts are made using the information available in what financial economists
call information sets. The larger the information set, the more accurate the
forecasted price (information is power).
Traditionally, these information sets have been classified into three categories: 1)
past asset price data, 2) information that is probably available, and 3) private
information. If all past information is incorporated in the price then it should be
impossible to ...