Stock Market Efficiency

There are three types of stock market efficiency, these are said to be; operational, allocational and pricing.

Operational efficiency relates to the speed, cost and reliability of transactions on the exchange. The market tries to carry out its operations as quick, reliably and as cheaply as possible. In order to do this competition is created between brokers so they can earn only normal profits not excessively high profits.

Allocational efficiency - Firms with the greatest potential to investment funds need a method to channel their funds their way. Stock markets help in allocating resources between competing investments. For example, an efficient market provides vast funds for the growth of the electronics, pharmaceuticals and biotechnology industries but allocates only small amounts to slow growth industries.

Pricing efficiency - the investor can expect to earn merely a risk adjusted return from an investment as prices move instantaneously in an unbiased manner.

In order to see how efficient the market is, there are three different forms of efficiency (Arnold, 2008)

1. Weak form efficiency - This is where the share price reflects all the PAST information, and therefore this past information reflects the price today.

2. Semi-strong form efficency - This focuses on the question of whether it is worthwhile acquiring and analysing publicly available information. This form of efficiency reflects all historic and publicly available information whilst being able to react quickly and rationally to new information

 

3. Strong form efficiency - where the share price reflects all known information, whether that be publicly available or not. This type of efficiency would however suggest that everyone knows everything about the company at any one time, which cannot be the case, as businesses regularly make company announcements that were unexpected to the shareholders and at the same time information can be leaked and cause controversy amongst shareholders as it was not news they were expecting.

On the other hand, stock markets can surprise investors and shareholders regularly which is why they are deemed to be unpredictable and why companies and investors lose and gain vast amount of profits.

This in turn leads on to Kendal (1953) and his Random Walks theory, whereby price changes are completely random based on all information that is known by the shareholders at the time of change, and changes in turn occur when new information enters the market. This thoery seems to me the most reasonable thoery because of the unpredictability of the market and how the shareholders will react.