Efficient Markets

FINC3017 Essay

There are four main types of investors in the market: institutional investors (banks and managed funds), insider traders, HFTs and retail investors. The institutional investors and most HFTs have significantly higher economies of scale and research and analytical power, whilst most individual investors are more restricted in that sense. There are several ways that investors’ activities can impact the efficiency of the market. Firstly, the investors’ activities can substantially distort the stock prices away from their intrinsic value. Even though EMH allows for random walk, some stocks can be significantly mispriced for considerable periods of time. Secondly, investors’ actions can affect the liquidity of stocks which is eventually reflected in the stock price. Lastly, investors can impact the volatility of stocks which in turn can also affect the stock’s price and attractiveness.

Insider traders which include directors, managers, workers and other associated professionals can use the inside information to earn abnormal returns. Insider trading can be legal and illegal depending on the authority of the trader and any legal insider trading activities must be officially disclosed to the Security Exchange Commission (SEC) which publishes this information to the general public. Possessing the insider information about the company systematically earns the abnormal returns to insiders, however, it has been shown that outside investors’ net profit after all trading costs on trades, which mock those of the insiders, after the insider activity have been published by the SEC, is systematically negative (Seyhun N., 1986). The fact that outsiders cannot profit on this information is consistent with EMH. However, insider trading results in the stock prices not fully reflecting this “new” information since the insider trading is of a smaller scale, but they rather move slowly towards the fair price which is established after the public announcement hereby contributing to the informational efficiency of the market since they ‘improve the flow of firm-specific information into stock prices’ (Piotroski and Roulstone 2004). The smaller scale of insider trading is explained by numerous laws prohibiting the transfer of insider information to the outsiders. This fact renders the strong-form efficiency invalid however the semi-strong efficiency still holds and is improved by insider trading despite being substantially limited by law. The insider traders are not affected by the public news announcements since they are already in possession of this information and make their investments accordingly.

The High-Frequency Traders (HFTs), having high purchasing power, make profits from submitting enormous numbers of buy-sell orders, usually earning a fraction of a cent on each transaction, at ultra-high speed. Despite executing enormous amounts of orders each second, HFTs do not normally affect the stock prices significantly because they do not try to outperform the market but rather they correct the smallest market inefficiencies (arbitrage) through exploiting them which earns them their profit. HFTs also significantly improve the liquidity of the stocks through trading at high-frequency. This helps other investors buy and sell their stocks in a timely manner which reduces the stock’s possible liquidity premium and transaction costs for ordinary investors (Manahov, Hudson and Gebka 2014). Retail investors, unlike other investor types, do not normally possess purchasing power, access to short-selling, economies of scale and have relatively limited knowledge. The EHM assumes that retail investors are risk-averse. This assumption has been empirically proven to be wrong (Barberis and Huang 2001). The individual investors are rather loss-averse and show signs of significant overreaction to news, especially bad ones. This leads to distorted prices in the short-medium-run as retail investors, when trading en masse based on news, affect the stock prices because it takes time for the market to correct (Barber, Odean and Zhu 2008). It has also been shown that retail investors may have significant influence over the small cap stocks’ prices as opposed to large cap stocks where institutions have a significantly higher influence (Barber, Odean and Zhu 2008). However, it was argued that retail trading actually leads to more accurate pricing of securities on average (improving market efficiency), despite retail traders trading with relatively little knowledge and higher transaction costs and bringing a lot of noise and volatility into the market (Evans A. 2009). Nevertheless, some negative influence of individual investors can be offset by the liquidity that they bring to the market hereby contributing to the market efficiency.