Are Financial Markets Efficient or Inefficient?

Discussion One: Are Financial Markets Efficient or Inefficient?

The efficiency of financial markets has been a subject of discussion in financial press and academic journals for decades. In 1970, Eugene Fama developed the efficient market theory (EMH) which contends that the security prices imitate all the information in the financial markets. Here, the prevailing stock prices reflect all pertinent information. Thus, if a financial market is efficient the best estimation of the security’s true value is the present market price and any deviance from the security’s true value would result in mispricing and the arbitrageurs will play their part by driving the market prices instantly toward the true value.

Most investors like the investment managers attempt to pinpoint securities that are undervalued and so, they are projected to rise in value in the near future, and mainly those that will rise more than the others. They are inclined to believe that they can choose securities using forecasting and valuation methods that can outperform the financial market. Clearly, any edge that investors possess can be converted into considerable profits. The EMH stresses that none of the methods are effective since the gain does not surpass the research and transaction costs and consequently, no one can surely outperform the financial market.

Similarly, one of the most critical implications of the EMH principle is that at any particular time, securities’ prices in efficient markets imitate all known information that is available to the investors. There is no likelihood of fooling the investors, and thus, all the investments in the efficient markets are deemed as fairly priced. On average, the investors get just what they have paid for. The fair pricing of securities does not infer that they can perform equally, or that the probability of rising or falling prices is similar for all the securities. There are some forces which prevent the prices of securities from being unfair. In accordance to the capital markets model, the projected returns from a security is mainly a function of risk. The prices reflect the present value of the projected future cashflows, which integrates numerous factors like volatility, liquidity, and bankruptcy risk.