Efficient Markets
There is an important corollary to a perfect market. A market (or a price) is called “efficient” if this market has set the price using all available information. If a market is perfect, it will inevitably also be efficient. If it were inefficient, you could become rich too easily. For example, say the market wanted to offer you an expected rate of return of 15% on a particular stock (for whatever reason), and the expected value of the stock is $115. Then the price of the stock today would have to be $100 for this market to be efficient. This market would not be efficient set the price for this stock at $99 or $101, because the stock would then offer other than the 15% expected rate of return. Similarly, you should not be able to locate information that tells you today when/if/that the true expected value tomorrow is really $120 for the $100 stock. If you could find this information, you could on average earn more than 15%. If the market has overlooked this information, it is not efficient.
The application and use of the “efficient markets” concept faces a number of issues. First, where does the 15% come from? It will have to come from some model that tells you what rate of return a stock should have to offer (given its characteristics, such as risk). Without such a model, talking about market efficiency is meaningless. Second, what information exactly are we talking about? Insiders often have more information than the public. For example, a drug company executive may know before ordinary investors whether a drug is likely to work. Thus, the market may be efficient with respect to publicly available information, but not efficient with respect to insider information.
So, to be more accurate, when a market is perfect, we usually believe that it is also efficient with respect to public information. After all, if other buyers and sellers were to ignore a useful piece of information, you could likely earn a lot of money trading on it. For example, what would you do if you learned that the market always goes down on rainy days and up on sunny days? It is unlikely that the average investor requires extra return to hold stocks on sunny days—and, even if the average investor does, you would probably not! You would never buy stocks when the weather forecast predicts that rain is coming, and you would only buy stocks when the weather forecast predicts that the sun will be shining. Investors like yourself—and there are of course many such investors in perfect markets—would rapidly bid up the prices before the sun was shining, so that the prices would no longer systematically go up on sunny days. If markets are efficient, then you should not be able to earn abnormally good sunny-day returns—at least not this easily. To earn higher expected rates of return, you must be willing to take on something that other investors are reluctant to take on—such as higher risk (also the subject of Part III).
A belief in efficient markets is what defines classical finance. In contrast, behavioral finance believes that markets sometimes do not use all information. Depending on how strong a believer in classical finance vs. behavioral finance you are, you may believe that there are no such opportunities, that there are few such opportunities, or that there are plenty of such opportunities. Both camps agree, however, that market perfection (and especially competitiveness and transaction costs) play crucial roles in determining whether a market is efficient or not. We will dedicate a few posts to market efficiency and its consequences, which will also talk in greater length about classical vs. behavioral finance.