| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
It is the actions of investors, sensing bargains and putting into effect schemes to beat the marketNecessary conditions for market efficiency Markets do not become efficient automatically. It is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that make markets efficient. The necessary conditions for a market inefficiency to be eliminated are as follows (1) The market inefficiency should provide the basis for a scheme to beat the market and earn excess returns. For this to hold true (a) The asset (or assets) which is the source of the inefficiency has to be traded. (b) The transactions costs of executing the scheme have to be smaller than the expected profits from the scheme. (2) There should be profit maximizing investors who (a) recognize the potential for excess return (b) can replicate the beat the market scheme that earns the excess return (c) have the resources to trade on the stock until the inefficiency disappears The internal contradiction of claiming that there is no possibility of beating the market in an efficient market and requiring profit-maximizing investors to constantly seek out ways of beating the market and thus making it efficient has been explored by many. If markets were, in fact, efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. It makes sense to think about an efficient market as a self-correcting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously as investors find them and trade on them. Propositions about market efficiency A reading of the conditions under which markets become efficient leads to general propositions about where investors are most likely to find inefficiencies in financial markets Proposition 1: The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. To the extent that investors have difficulty trading on a stock, either because open markets do not exist or there are significant barriers to trading, inefficiencies in pricing can continue for long periods. This proposition can be used to shed light on the differences between different asset markets. For instance, it is far easier to trade on stocks that it is on real estate, since markets are much more open, prices are in smaller units (reducing the barriers to entry for new traders) and the asset itself does not vary from transaction to transaction (one share of IBM is identical to another share, whereas one piece of real estate can be very different from another piece, a stones throw away. Based upon these differences, there should be a greater likelihood of finding inefficiencies (both under and over valuation) in the real estate market. Proposition 2: The probability of finding an inefficiency in an asset market increases as the transactions and information cost of exploiting the inefficiency increases. The cost of collecting information and trading varies widely across markets and even across investments in the same markets. As these costs increase, it pays less and less to try to exploit these inefficiencies. Consider, for instance, the perceived wisdom that investing in loser stocks, i.e., stocks that have done very badly in some prior time period should yields excess returns. This may be true in terms of raw returns, but transactions costs are likely to be much higher for these stocks since (a) they then to be low priced stocks, leading to higher brokerage commissions and expenses (b) the bid-ask spread, a transaction cost paid at the time of purchase, becomes a much higher fraction of the total price paid. (c) trading is often thin on these stocks, and small trades can cause prices to change resulting in a higher buy price and a lower sell price. Corollary 1: Investors who can establish a cost advantage (either in information collection or transactions costs) will be more able to exploit small inefficiencies than other investors who do not possess this advantage. There are a number of studies that look at the effect of block trades on prices, and conclude that while they affect prices, that investors will not be exploit these inefficiencies because of the number of times they will have to trade and their transactions costs. These concerns are unlikely to hold for a specialist on the floor of the exchange, who can trade quickly, often and at no or very low costs. It should be pointed out, however, that if the market for specialists is efficient, the value of a seat on the exchange should reflect the present value of potential benefits from being a specialist. This corollary also suggests that investors who work at establishing a cost advantage, especially in relation to information, may be able to generate excess returns on the basis of these advantages. Thus a John Templeton, who started investing in Japanese and other Asian markets well before other portfolio managers, might have been able to exploit the informational advantages he had over his peers to make excess returns on his portfolio. Proposition 3: The speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the inefficiency can be replicated by other investors. The ease with which a scheme can be replicated itself is inversely related to the time, resources and information needed to execute it. Since very few investors single-handedly possess the resources to eliminate an inefficiency through trading, it is much more likely that an inefficiency will disappear quickly if the scheme used to exploit the inefficiency is transparent and can be copied by other investors. To illustrate this point, assume that stocks are consistently found to earn excess returns in the month following a stock split. Since firms announce stock splits publicly, and any investor can buy stocks right after these splits, it would be surprising if this inefficiency persisted over time. This can be contrasted with the excess returns made by some arbitrage funds in index arbitrage, where index futures are bought (sold), and stocks in the index are sold short (bought). This strategy requires that investors be able to obtain information on index and spot prices instantaneously, have the capacity (in terms of margin requirements and resources) to buy and sell index futures and to sell short on stocks, and to have the resources to take and hold very large positions until the arbitrage unwinds. Consequently, inefficiencies in index futures pricing are likely to persist at least for the most efficient arbitrageurs, with the lowest execution costs and the speediest execution times. Testing market efficiency Tests of market efficiency look at the whether specific investment strategies earn excess returns. Some tests also account for transactions costs and execution feasibility. Since an excess return on an investment is the difference between the actual and expected return on that investment, there is implicit in every test of market efficiency a model for this expected return. In some cases, this expected return adjusts for risk using the capital asset pricing model or the arbitrage pricing model, and in others the expected return is based upon returns on similar or equivalent investments. In every case, a test of market efficiency is a joint test of market efficiency and the efficacy of the model used for expected returns. When there is evidence of excess returns in a test of market efficiency, it can indicate that markets are inefficient or that the model used to compute expected returns is wrong or both. While this may seem to present an insoluble dilemma, if the conclusions of the study are insensitive to different model specifications, it is much more likely that the results are being driven by true market inefficiencies and not just by model misspecifications. There are a number of different ways of testing for market efficiency, and the approach used will depend in great part on the investment scheme being tested. A scheme based upon trading on information events (stock splits, earnings announcements or acquisition announcements) is likely to be tested using an event study where returns around the event are scrutinized for evidence of excess returns. A scheme based upon trading on a observable characteristic of a firm (price earnings ratios, price book value ratios or dividend yields) is likely to be tested using a portfolio approach, where portfolios of stocks with these characteristics are created and tracked over time to see if, in fact, they make excess returns. The following pages summarize the key steps involved in each of these approaches, and some potential pitfalls to watch out for when conducting or using these tests. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |