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Relation to Perfect Market

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A perfect market is not an efficient market. They are intimately linked but their concepts are different. But, when a market is perfect, it inevitably becomes efficient. Suppose, there is an inefficient market, but its conditions are perfect. Hence, every investor will plan to earn high returns and start trading. It will be easy to become rich, but the market will adjust its prices to prevent these circumstances. So, the market proves itself efficient.

But, the other at round is not true. In an efficient market, various trades will take place as numerous investors will receive many sets of opinions. Eventually, the market price will be such that there will be no trade any further. The price will be too high for some and too low for other half. Thus, it will stay an imperfect market.

It is assumed, that ignoring the transaction cost in trades, acts as a catalyst to drive the market from perfect to efficient. Without it, investors easily go into trades with available information and earn unusually higher rate of return. High transaction cost can most likely violate efficient markets. But, without immediate responses to this news, it is hard to avail these advantages.

Perfect market or efficient market:  

For instance; the weather conditions affect the rise and fall of prices in market. It goes down on a rainy day and up on a sunny one. So, you will never buy a stock when the weather is predicted rainy. Instead you will invest on a sunny day. Now, there are investors, who will bid the prices up for sunny day before the sun even shone. Hence, there will be no systematic rise in the invested money on a sunny day. So, in an efficient market; you will be able to earn higher amounts easily.

Imperfect market to efficient:            

It is easier to believe that if transaction costs are high the market is less efficient. For example; the expected rate of return for PepsiCo is 10%, which is for today’s $50, it will be $55. But, you find out that the current price is $58. Hence, your rate of return will turn negative, that is -5.2%. Thus, in a perfect market investors will start selling their stocks; while it is not possible if the market is not perfect.

This new pricing is driven by self-interested economic behavior, which makes the market efficient even if it is not perfect.

Four things to learn:

  • A perfect market can make the very market efficient. But vice-versa is not possible.
  • Transaction costs can pull down efficient pricing levels.
  • Competition among investors can make a market efficient.
  • Pricing may make a market efficient even if it is imperfect. But, this is a weaker possibility as third-party trader may not support it.

11.1 C Market Efficiency in Modern Financial Markets

You can assume that markets are efficient because of large corporate stocks. Likewise in United States; markets for Treasuries, index mutual funds, stocks of large scale corporate, currencies and many more are highly competitive but also reasonable efficient. There are numerous buyers, thousands of investors who hardly have any inside information but are the smartest among the markets. They bid for good bargains and avoid the bad ones.

Smaller firms tend to have less efficient market status. But, various small stocks according to NASDAQ exchange trade have higher transaction costs because:

  • High bid-ask spread is guaranteed for only 100. Prices may move against you if you try to trade more than 100 shares in the posted spread.
  • Rising commissions.
  • It may be costly to short small stocks.

For round trip transactions, you may face the first three issues. Small stock may not reflect accurate information immediately. While the posted prices may be stale and is of no use to apply on trades. So, small NASDAQ stocks may not be market efficient like large stocks.

If large firm stocks are efficient; you can trust these asset values in the financial market. If the market would have been inefficient; as an investor you may get some good bets. But, you could not rely on the market pricing. They may be either too high or too low. Thus you will have no idea of over price or under price and this investing business may become messy.

On the other hand, in an efficient market you do not have to spend your time in performing due diligence to determine if the stocks are fairly priced.

11.2 Classifications of Market Efficiency Beliefs and Behavioral Finance

Classical Finance is a thought related with belief in efficient market. Their beliefs support the theory of EMH or efficient market hypothesis. In this theory, all the securities are priced fairly. Another theory of behavioral finance suggests not using all the available information.

Depending on your beliefs either on any of the two theories an investor may believe;

  • There are no good trading opportunities.
  • Some few opportunities.
  • Or there are plenty trading chances.

Despite these beliefs, all financial economists have believed on an efficient market regardless of large or liquid securities. While, none believes that with easily available information it is easy to get rich. Thus the disagreement is loosely bound to the grounds; ‘99% efficient’ and ‘97% efficient. Behavioral finance believes in the latter concept and Classical believes in the former.

As, you can trade millions on large scale firm stock or markets with lower transaction costs; there is no efficiency violations. This is where behavioral finance is right and the other is wrong. A tiny percentage of violation can make you a good investor.

11.2 A the Traditional Classification

According the traditional definition; information is the key to efficient market. Thus there are three market strengths:

Weak market efficiency: Where the information regarding past prices reflects and affects today’s price. So, one cannot set the price using technical analysis. Market it in the best analyst.

Semi-strong market efficiency: All public information affects today’s price set. So, you cannot beat the market using fundamental analysis. In this case, market acts as both fundamental and technical analyst.

Strong market efficiency: In this scenario, market cannot be beat. As, all information including private and public reflects today’s price.

Depending on this traditional classifications- almost all financial professor believes that most markets are not strongly efficient. Though insider trading is illegal, it does work. There are regular arguments over large and liquid markets; if it is semi-strong or weak.

There are published papers discussing about new found rules. Some are strategically approaches to offer excess returns which may range from 1% to 2% per month.

Some strategies have spurious returns; that they disappear immediately after discovery. And some required high transaction costs; that they turned out to be non-profitable in real world. And yet, there are some strategies which have high transaction costs but produces huge expected rate of return. But two questions remain unanswered:

  • If these strategies will continue to work for long run?
  • Is the part of return appropriate for compensation of all the taken risks during beginning?

The concept of efficient market seems paradoxical. If there is way to make money from a market, what is the need in collecting information? And if nobody collects the information- how can a market be efficient?

This was solved by Gross man and Stieglitz. They stated that no market can be sent percent efficient. It can be only 99%. And when a market reaches equilibrium; an expert in collection information can earn enough trading profit. And, the margin of earning through learning and collecting information turns out to be equal to trading profits. Is becomes easy to earn by trading against noise trades who do not collect information.

 

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