Stock Market

When investors or individuals put money into the stock market, their goal is to receive a return on the capital invested. Many investors try not only to make a profitable return, but also want to outperform or beat the stock market. For this situation, Eugene Fama suggests that at any given time, prices fully reflect all available information on a particular stock and no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

Many financial researches recognize that the financial markets are informationally efficient as the market prices fully show publicly available information. But the market may not attain such efficiency when publicly available information is costly to produce and when investors can always purchase better information at a higher price. While, when investors stop to buying information and trade shares, the amount of information purchased by the public and the quality of information reflected in the market price can be endogenous. Therefore, market efficiency relies on the cost structure of producing information, investors’ behaviors and risky return.

Market efficiency does not require prices to be equal to fair value all the time. Generally, stock prices would be over or lower than the actual prices but eventually revert back to their mean values. This is because the deviations form a stock’s fair prices are in themselves random, investment strategies that result in beating the market cannot be consistent phenomena. Furthermore, the hypothesis argues that an investor who outperforms the market does so not out of skill but out of luck. However, we cannot deny that in the real world of investment, there exists investors that have beaten the market, for instance, Warren Buffet, whose investment strategy focuses on undervalued stocks, made millions and set an example for numerous followers.

There are three levels of efficiency, weak form efficiency, semi strong form efficiency and strong form efficiency, which are used to reflect in prices and to define whether the market is efficiency. For weak form efficiency, share prices fully reflect all information contained in past price movements. But it is useless for investors to gain profit based on share price history. Semi strong form efficiency, share price indicates all the relevant publicly available information, which implies that there is no advantage in analyzing publicly available information after it has been released, because the market has already absorbed it into the price, therefore, investors technical analysis cannot result in profits but internal information may bring in profits. Strong form efficiency, all relevant information, including that which is privately held, is reflected in the share price. In this market, even insiders are unable to make abnormal profits for investors.

Take the HP acquired Autonomy as an example. The US stock market can be considered in the level of semi strong form efficiency market. As the management overprice the Autonomy's share price, HP made a $8.8 billion loss after 15 months of the acquisition.This is owing to the fact that Autonomy has inflated in their accounting data, which belongs to a insider information. If the HP's managers has discovered the forge before the acquisition, they would not overprice the share price and result in great losses.

It is important for the market to be efficient. Because a more efficient market encourages individuals invest in private enterprise. If shares are incorrectly priced many savers will refuse to invest because of a fear that when they come to sell the price may be perverse and may not represent the fundamental attractions of the firm. Secondly, as the object of one company is to create shareholders value, this provides a signal for company managers to make a sound decision. In addition, share prices signal the rate of return investors demand on securities of a particular risk level. If the market is inefficient the risk return relationship will be unreliable so that managers might misestimate the price, leading to excessive high cost capital. Thirdly, valuation of the stock market helps the company allocate resources, including operating efficiency and pricing efficiency.