Market efficiency refers to the notion that all publicly available information about a security is already reflected in its current market price, making it difficult to outperform the market by buying undervalued securities or selling overvalued securities. In other words, in an efficient market, the prices of securities reflect all available information and new information is immediately reflected in the prices.
There are three forms of market efficiency: weak form, semi-strong form, and strong form.
Weak form efficiency refers to the idea that past price and returns information are reflected in the current price, making it impossible to consistently achieve abnormal returns using only that information.
Semi-strong form efficiency goes one step further and states that all publicly available information, including company financials, news, and analyst reports, is reflected in the current price, making it impossible to achieve abnormal returns using such information.
Strong form efficiency suggests that even insider information is reflected in the price, making it impossible to achieve abnormal returns through the use of such information.
Despite the notion of market efficiency, anomalies exist in financial markets. Anomalies are departures from the predictions made by the efficient market hypothesis and can be seen as evidence against market efficiency. Some examples of anomalies include the following:
- Momentum effect: The momentum effect states that securities that have performed well in the past tend to continue to perform well in the future, and vice versa. This is contrary to the efficient market hypothesis, which suggests that all information is reflected in the price and the future returns cannot be predicted.
- Value effect: The value effect suggests that value stocks, or stocks that are undervalued relative to their fundamentals, tend to outperform growth stocks, or stocks that are overvalued relative to their fundamentals.
- Size effect: The size effect states that small cap stocks tend to outperform large cap stocks.
- Earning surprises: The earning surprises anomaly suggests that stocks that have outperformed or underperformed earnings expectations tend to continue to outperform or underperform in the future.
- Calendar anomalies: Calendar anomalies refer to deviations from expected returns that are related to the calendar. For example, the January effect states that small cap stocks tend to outperform in the month of January, while the turn-of-the-month effect suggests that stock returns tend to be higher at the beginning and end of a month.
- Industry and sector effects: Industry and sector effects refer to the tendency for stocks within the same industry or sector to move together.
There are several explanations for the existence of anomalies in financial markets, including the following:
- Limits to arbitrage: In an efficient market, any deviation from fair value would be quickly arbitraged away. However, in practice, there are limits to arbitrage that can prevent the market from fully correcting anomalies. For example, the size of the deviation, transaction costs, and the ability to short a stock can all limit the ability of market participants to correct anomalies.
- Behavioral biases: Behavioral biases, such as overconfidence and herding behavior, can also contribute to the persistence of anomalies. For example, if investors are overconfident in their ability to predict future stock prices, they may be more likely to hold onto losing stocks and sell winning stocks, leading to the persistence of the momentum effect.
Market frictions: Market frictions, such as illiquidity and limited attention, can also contribute to the persistence of anomalies. For example, if it is difficult to buy or sell a stock due to illiquidity, market participants may be unable to fully correct an anomaly, leading to its persistence.