A market is efficient when security prices reflect all the available information.

Under ideal conditions, information is free and investors have the opportunity to take advantage of available information and make rational decisions about securities prices in the market. Under non-ideal conditions, information is not free and investors have to do cost benefit analysis in order to decide how much information they acquire to make rational decisions. There are three types of efficient markets: weak form, semi-strong form, and strong form. We will discuss only semi-strong markets where all publicly available information about specific securities is reflected in securities price. When new information enters the securities market, prices will adjust quickly because investors will revise their prior beliefs.

They will start selling and buying securities based on their new beliefs and this will cause changes in prices. It means that market prices are relative to publicly available information. Fluctuation in the market is expected due to the seasonal nature of business, or retirement of key employees, etc. The time series in which a particular securities price has random fluctuations, over a period of time, is called random walk.

The notion that market prices reflect the information available is explained by decision theory. We know from previous chapters that rational, informed investors will demand all available information on securities. This theory does not guarantee that each investors decision will be same. Each investors decision will differ based on their prior beliefs as one or more inputs may differ. For example, investors may misidentify one or more probabilities required by Bayes theorem. If a specific number of investors interpret information properly they will make proper buy and sell decisions about securities. Other investors will follow their recommendations and the resulting prices will properly reflect all available information in a timely manner.

The Capital Asset Pricing Model explains the relationship between the efficient market price, risk, and the expected rate of return on a security. The model answers the question, how do the investors find the rate of return on their investment? The rate of return on a share = (the price at the end of period + dividends paid) / price at the beginning of the period of a share. One is then subtracted from this value. We can also find the expected return on a share by using the expected price plus any dividends expected at the end of period. Thus, the CAPM relationship is: E (Rjt) = Rf + Bj [E (Rmt) Rf] where Rf is rate of return on a risk free asset such as Tbills, Bj is the beta of security j, and Rmt is the return on the market portfolio for period t. This model takes risk factors into account, denoted by beta of the security j.

There are two types of risk: systematic risk and non-systematic risk. Non-systematic risk is firm specific, which can be eliminated in a diversified portfolio and does not affect share price. Systematic risks are economy-wide, as all firms will be affected by these factors in turn affecting share price. Beta can also change over time if the risk of a firm or industry changes.

What is an Anomaly? Efficient securities market anomalies are investor behaviour that appears to contradict the theory of efficient markets. Rational single-person decision theory is called into question. Prospective theory: An investor considering a risky investment (a prospect) will evaluate separate prospective gains or losses. The utility for gains is concave and risk averse while the utility for losses is convex, and risk taking. Investors weight payoff probabilities. This can lead to irrational behaviour, which turns anomalous if many act this way.

Behavioural finance: This is the study and documentation of abnormal security returns persisting for a length of time following an information event.

Post-announcement drift: When good news (GN) is reported, abnormal security returns drift upwards for at least sixty days. When bad news (BN) is reported, abnormal security returns drift downwards for at least sixty days. The reason this occurs is the art fact of earnings expectation model used by researchers is up in the air. However, investors seem to underestimate the implications of current earnings for future earnings. As well, the correlation between GN in one quarter and the next is underestimated.

The market waits so details appear of the strategy to beat the market. O u and Penman (OP) calculated 68 ratios for a number of firms. They saw that ratios predicted net income (NI) rising or falling in the next year. The best ratios were used as independent variables to estimate a multivariate regression model to predict changes in the next year NI. This is an anomaly for efficient securities market theory.

Explaining anomalies without leaving the efficient securities market theory was attempted with risk. But, rewards from risky stocks were not driving results. The firm size explains share returns in addition to beta. Results from OP reflect a permanent difference in the expected returns such as firm size or risk, rather than deviation from fundamental value. Transaction costs are another explanation for anomalies, as these costs limit the ability of investors to exploit postannouncement drift. So, unless we know what the cost of an investment strategy should be, we wont know whether profits earned are anomalous.

The first implication is accounting policies adopted by firms dont affect their security prices, as long as policies are disclosed, have no differential CF effects, and information is given so readers can easily convert across policies. The second implication is that efficient securities markets go hand in hand with full disclosure. The next implication is that market efficiency implies financial statement information doesnt need to be presented in an elementary form for everyone to understand. Nave investors are price-protected as they can trust the efficient market to price securities. Finally, if accountants didnt provide useful, costeffective information, the usefulness of this function would decline to other information sources.

In efficient markets, the price of a security is fully informative; it fully reflects all available information of that security. Since information gathering is costly, and investors could not expect to beat the market, they will not be motivated to gather information. The logical inconsistency is this: if prices fully reflect available information, investors will not gather information; hence, prices will not fully reflect available information. The potential implication of this inconsistency is that financial statements may not be useful to investors. The inconsistency is avoided because of the presence of liquidity traders or noise traders. These types of investors are irrational and make buy/sell decisions at random. As a result, share prices are only partially informative as they are now mispriced. Rational investors can gather more information about securities by carefully analyzing financial statements. Hence, financial statements are useful to investors.
Their usefulness can be enhanced by MD&As and FOFIs

Securities markets are subject to information asymmetry problems. Namely, it is likely that insiders know more than outsiders about the true quality of the firm, and the possibility exists that insiders will take advantage of this information to earn excess profits. This situation is an example of adverse selection. Investors are aware of this possibility and will lower the amounts they are willing to pay for shares. Thus, the securities markets do not work as well as they might. Financial reporting serves to reduce the adverse selection problem, thereby improving the operation of securities markets. Specifically, the full disclosure policy serves to expand the set of information that is publicly available. Also, timelines of reporting will reduce the ability of insiders to profit from their information advantage.

There is a social significance of properly working securities markets. If information asymmetry exists, firms with high-quality investment projects will not receive a high price for their securities, and the market is not working as well as it should. However, penalties against insider trading and the requirement of full disclosure are mechanisms by which the smooth operation of securities markets is maintained.

In the securities market is based upon the underlying principle of publicly available information. While a companys financial statements reveal to us valuable information about their current financial standings, investors often desire to know more about a particular company in order to make informed investment decisions. For this reason, many companies follow a policy of full disclosure through the use of accounting standards such as Management Discussion and Analysis (MD&A) and Future-Oriented Financial Information (FOFI).

In accordance with Statement 5.10 and the Ontario Securities Commission (OSC), MD&A is required for large firms (i.e. those firms with shareholders equity and revenues in excess of $10 million), but is optional for all others. MD&A focuses on the decision usefulness approach, attempting to provide users with relevant information to assess the future prospects of a firm. The MD&A disclosure requires discussions on current operations and financial conditions, risks and uncertainties, financial instruments, known trends, and any other information that is not clearly presented in the financial statements, but which can be obtained without undue effort or expense to the firm. MD&A is separate from the financial statements, however, its purpose is much the same to provide investors with useful information that allows them to assess the future prospects of a firm.

FOFI is another financial forecasting standard that aims to further expand the information available to investors. Under Section 4250 of the CICA Handbook, FOFI is not required. However, many firms choose to engage in this standard to enhance their reputation for full and timely disclosure to their users, and in the case of smaller corporations, to reveal more information about themselves to the public. It is suggested that FOFI not exceed a period of approximately one year, for beyond such a time the information may not be reasonably estimated. In order to maximize the usefulness of FOFI, it is formatted in such a way that is commonly known and understood by users. Providing a linkage between past and future results, FOFI allows for comparability over time and provides disclosures that are important and potentially useful to investors. Full disclosure through the use of MD&A and FOFI standards allow companies to communicate information to the public beyond what is presented in their conventional financial statements. Investors can learn a lot about a firm based on the information that they disclose and to what extent they disclose it.

The classic statements of the Efficient Markets Hypothesis (or EMH for short) are to be found in Roberts (1967) and Fama (1970). An efficient market is defined as a market where there are large numbers of rational, profit maximisers 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. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

In its strongest form, the EMH says a market is efficient if all information relevant to the value of a share, whether or not generally available to existing or potential investors, is quickly and accurately reflected in the market price. For example, if the current market price is lower than the value justified by some piece of privately held information, the holders of that information will exploit the pricing anomaly by buying the shares. They will continue doing so until this excess demand for the shares has driven the price up to the level supported by their private information. At this point they will have no incentive to continue buying, so they will withdraw from the market and the price will stabilise at this new equilibrium level. This is called the strong form of the EMH. It is the most satisfying and compelling form of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm empirically, as the necessary research would be unlikely to win the cooperation of the relevant section of the financial community insider dealers.

In a slightly less rigorous form, the EMH says a market is efficient if all relevant publicly available information is quickly reflected in the market price. This is called the semi-strong form of the EMH. If the strong form is theoretically the most compelling, then the semistrong form perhaps appeals most to our common sense. It says that the market will quickly digest the publication of relevant new information by moving the price to a new equilibrium level that reflects the change in supply and demand caused by the emergence of that information. What it may lack in intellectual rigour, the semi-strong form of EMH certainly gains in empirical strength, as it is less difficult to test than the strong form. One problem with the semi-strong form lies with the identification of relevant publicly available information. Neat as the phrase might sound, the reality is less clear-cut, because information does not arrive with a convenient label saying which shares it does and does not affect. Does the definition of new information include making a connection for the first time between two pieces of already available public information?

In its third and least rigorous form (known as the weak form), the EMH confines itself to just one subset of public information, namely historical information about the share price itself. The argument runs as follows. New information must by definition be unrelated to previous information, otherwise it would not be new. It follows from this that every movement in the share price in response to new information cannot be predicted from the last movement or price, and the development of the price assumes the characteristics of the random walk. In other words, the future price cannot be predicted from a study of historic prices. Each of the three forms of EMH has different consequences in the context of the search for excess returns, that is, for returns in excess of what is justified by the risks incurred in holding particular investments. If a market is weak-form efficient, there is no correlation between successive prices, so that excess returns cannot consistently be achieved through the study of past price movements. This kind of study is called technical or chart analysis, because it is based on the study of past price patterns without regard to any further background information.

If a market is semi-strong efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all publicly available information about the risk and return of an investment. The study of any public information (and not just past prices) cannot yield consistent excess returns. This is a somewhat more controversial conclusion than that of the weakform EMH, because it means that fundamental analysis the systematic study of companies, sectors and the economy at large cannot produce consistently higher returns than are justified by the risks involved. Such a finding calls into question the relevance and value of a large sector of the financial services industry, namely investment research and analysis

If a market is strong-form efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all relevant information, whether the information is in the public domain or not. As we have seen, this implies that excess returns cannot consistently be achieved even by trading on inside information. This does prompt the interesting observation that somebody must be the first to trade on the inside information and hence make an excess return. Attractive as this line of reasoning may be in theory, it is unfortunately well-nigh impossible to test it in practice with any degree of academic rigour.

The EMH version that most interests us (semi-strong) has strong factual support, although it is arguable to say that it is conclusive. Personally I take it to be not totally true but to a high degree, and that level of acceptance is enough for inferring some important practical conclusions: Stock picking takes, in the best of cases, a lot of work to be just feebly fruitful, so there are probably better things to do with our resources. Instead of picking stocks, it makes sense to buy passivelymanaged funds with low commissions, such as various ETFs, to obtain the market's average returns. If we are hiring professionals to do stock picking for us (which happens, for example, when we purchase shares of an actively-managed fund) their fees shouldn't be too high, because the potential benefits aren't.

Whenever we attempt to beat the market, by performing security picking ourselves or through a professional (fund manager), lets consider the rationale behind the EMH, to identify potential sources of market inefficiency. For example, we better not try to beat the market by analyzing large-cap companies, because lots of people are doing it, with the same information that is available to us. Instead, coming to know a small company and a niche market could put us (or our fund manager) in an advantageous position compared to the rest of the market. Therefore, active management sounds like a better idea for small-cap funds than for large.

Don't feel too bad if you bought a security and then its price fell, you only were as silly (or intelligent) as that fabulous team called the market. There are other better criteria for judging your portfolio-building skills.
EMH shouldn't be misinterpreted into thinking that there is no such thing as investment-portfolio design. There are still important decisions to make in order to obtain a portfolio with a risk that suits you; a good (expected) reward for that risk, and the lowest possible costs, meaning commissions and other fees. Modern Portfolio Theory is a set of theories that provide the basis for doing it, with EMH as one of its pillars, and will be treated in subsequent articles. Just as the EfficientMarket Hypothesis, much of the rest of Modern Portfolio Theory is easy to grasp and has immediate practical consequences, even for small investors.

For about ten years after publication of Fama's classic exposition in 1970, the Efficient Markets Hypothesis dominated the academic and business scene. A steady stream of studies and articles, both theoretical and empirical in approach, almost unanimously tended to back up the findings of EMH. As Jensen (1978) wrote: There is no other proposition in economics which has more solid empirical evidence supporting it than the EMH. However, as Shleifer (2000) put it, strong statements portend reversals and in the two decades following Jensen's statement, a growing volume of theoretical and empirical work either contradicted the EMH outright or sought at least to show that its case was not proven.

Critics of EMH have produced a wide range of arguments, of which the following is a summary. The assumption that investors are rational and therefore value investments rationally that is, by calculating the net present values of future cash flows, appropriately discounted for risk is not supported by the evidence, which shows rather that investors are affected by: herd instinct a tendency to churn their portfolios a tendency to under-react or over-react to news (Sheifer, 2000; Barber and Odean, 2000) asymmetrical judgements about the causes of previous p

Furthermore, many alleged anomalies have been detected in patterns of historical share prices. The best known of these are the small firm effect, the January effect and the mean reversion. The small firm effect. Banz (1981), in a major study of long-term returns on US shares, was the first to systematically document what had been known anecdotally for some years namely, that shares in companies with small market capitalisations (small caps) tended to deliver higher returns than those of larger companies. Banz's work was followed by a series of broadly corroborative studies in the US, the UK and elsewhere. Strangely enough, the last twenty years of the twentieth century saw a sharp reversal of this trend, so that over the century as a whole the small cap effect was much less marked. Whatever the reason or reasons for this phenomenon, clearly there was a discernible pattern or trend that persisted for far too long to be readily explained as a temporary distortion within the general context of EMH.

The January effect. Following on from the small firm effect, it was also observed that nearly all of the net outperformance by small cap stocks was achieved in successive Januarys. Again, this was a discernible trend that under EMH should have been arbitraged away. As one commentator rather acidly remarked, it was not as if the annual coming of January could be characterised as entirely fresh news! Mean reversion. This is the name given to the tendency of markets, sectors or individual shares following a period of sustained under-or out-performance to revert to a long-term average by means of a corresponding period of out- or underperformance. This was picked up in detailed research by De Bondt and Thaler (1985), who showed that, if for each year since 1933 a portfolio of extreme winners (defined as the best-performing US shares over the past three years) was constructed, it would have shown poor returns over the following five years, while a portfolio of extreme losers would have done very well over the same period.