Market Efficiency and Financial Managers

There are many technical analysts in the markets, trying to find best investments on securities by examining past prices, past earnings, track records and other indicators. However security prices are mainly based on investor expectations rather than their analysis. At this point, markets can be thought as efficient, under the condition of all available information is already reflected on security prices.

Efficient Market Hypothesis

"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants" (Euegene F. Fama cited in Investor Home, accessed 22^nd April 2006). Fama's idea formed the entire basis for this hypothesis. His argument was that markets include many qualified and well informed investors who value the securities appropriately and the prices reflect all of the information about state of the companies which issue them. Therefore price levels do not follow any pattern and past experiences cannot be used to predict future prices.

It is clear that no market can attain full efficiency all the time. Changes in the share prices are always possible whether they are caused by newly disclosed information.

However; it will take time for investors to take action to this information and for share prices to get their actual value. Following two diagrams illustrates how share prices are responding in the real markets.

 

There are three forms of the efficient market hypothesis: weak, semi-strong and strong. Each sets different level of relation between the information and security prices.

The weak form

This form asserts that price movements are on a random basis and does not depend on the past events. In this form, prices are assumed to follow the "random walk". Therefore it is not possible to predict the future prices by looking at historical share prices.

Semi-strong form

This form asserts that any public information about a company is reflected in its share price. This means it is no use to dig into the company reports, announcements or industry trends to find information that would be used to make superior returns. We can anticipate that a market that is efficient in the semi strong form will incorporate the features of the weak form as well.

Strong-form

This advances semi strong form one step further and asserts that even insider information along with the public information is reflected in company shares. This means that investors will not make higher return even if they acquire information such as management decisions or intentions. Thus it can be said that a market that is efficient in the strong form will incorporate the features of the semi-strong form and the weak form together.

Implications of Efficient Market

In the efficient market there are some implications that concern both investors and financial managers. It‘s been already explained that investors will not be able gain advantage consistently over the others by getting information about the companies. From the perspective of financial managers, there are important implications that must be considered too.

a) Managers should not waste time hoping to find undervalued company to takeover. We have seen that share prices reflect company value accurately and it is not possible to make profit with this way. Under the strong form of efficiency even inside information will make no use. There must be more persuasive reasons for takeovers.

b) Managers should not seek an appropriate time in order to issue new shares. In the efficient markets, prices always reflect true worth of company regardless of the seasons or months. Therefore managers should believe that share prices cannot be undervalued or overvalued and timing for new shares does not really matter.

c) Mangers should not try to fool the market. Market will never be cheated by any act of managers. The fair value is evaluated and given to shares. If a financial manager decides to give bonus issue to share holders just to imply company has performing well, investors will assess this correctly and price the shares accordingly.

d) Managers should accept the level of the risk evaluated by market. If company has new investments the return value of these investments and the contribution to the company value will be accurately assessed by market. Managers cannot do much about this judgment.

Conclusion

In reality there is no market that completely efficient. If they were efficient all the efforts to outperform the market would be meaningless. In fact what makes a market efficient is that these efforts. Some markets can be more efficient than the others, depending on how fast information spreads and how qualified are the investors. In the age of information news are spreading faster and accurately, leading more efficient markets. Therefore, both investors and financial managers have to accept the facts of the efficient market. Investors must accept that it is becoming harder to beat others using information. And companies cannot ignore the fact that most investors are very intelligent and the companies’ security prices reflect their performance very accurately