Stock market efficiency

By Shruti Datt on March 8, 2015
Image by Armando Arauz

While investing in the stock market, the main aim for anyone is to generate the return on invested capital. Investors aren’t only trying to get the profitable returns from investing capital, but they also expect to outperform in the market. However, the concept of market efficiency is better discussed through the efficient market hypothesis that suggests that prices should reflect information about the stocks and the markets.

How stocks work?

Financial theories are subjective in nature and there are no proven financial laws, rather there are ideas that explain how the stock market actually works. Firstly, the hypothesis of efficient market assumes that every investor tries to perceive more precise information. There are various methods for valuing the stocks that pose certain issues for the efficient market hypothesis. If one investor views the market opportunities as undervalued and other investor perceives the stock market on the basis of increasing potential, then definitely these two investors will come at the variant assessment of the fair market value of stocks.

Secondly, in the efficient market hypothesis, there are no individual investors that try to attain higher profitability than the similar invested funds and their similar information possession implies that they could achieve the common returns of their invested capital. As per the efficient market hypothesis, if one investor becomes profitable, it implies that the whole universe of investors will get profitable but in reality this cannot be the actual case.

Thirdly, in the efficient market hypothesis, there is no investor who can beat the market. According to the market experts, the best strategy of investment is formulated to place the investment funds within the index fund that might increase or reduce as per the entire corporate loss or level of profitability. There are many examples of the investors who have tried to consistently beat the market and one such example is Warren Buffett, who has managed to beat the market year after years.

Abnormal invested returns

In the discussion of stock market efficiency hypothesis, the assumption is that there are no investors who are able to generate the abnormal invested returns in the market. If such case happens, it’s expected from the investors to make equal returns with the market returns. It’s expected that investors should focus over reducing the invested cost. For achieving the rate of return in the market, it is required to have diversification in various stocks, which is not the best option in case of small investors.

In my opinion market wouldn’t achieve the perfect efficiency in near future; therefore, for higher efficiency, it’s better to adopt certain criteria like, having universal access to advanced systems and high speed system for conducting analysis of pricing; universally accepted system for pricing the stocks; no human emotions should be there while taking investment decisions, and the acceptance of investors to accept their loss or return that might be similar to the other participants in the market. Yes, it’s not easy to imagine any one of these market efficiency criteria to get met by the investors.

Shruti Datt
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