The myth of an efficient market, part 2/3: Preconditions for efficiency

In the previous part I described how market efficiency has been generally defined, and how it in my opinion should be understood in practice. I also defined an example formula for calculating market efficiency as a percentage. But what would it require in practice to actually achieve perfect efficiency? For each security there should at all times be enough willing buyers and sellers with adequate purchasing power and an exactly correct and adequately strong view about the correct price of the particular security. In principle one party interested in selling and one party interested in buying may suffice. However in order to form that exactly correct view and to actually follow that view to an adequate extent several preconditions should be met.

Worker bees on the good stuff
In order for the market to function fully efficiently, there needs to be perfect information. At its narrowest, the public information mentioned in the depiction of Fama's semi-strong efficiency could be understood as including merely the economical figures of the stock. However the future and thus the price of the company can under no circumstances be deducted from just these figures. A company has a specific business branch and a specific position in its field. The clients also have certain economic power and motivation to buy the products or services of the company, and in addition the whole economical atmosphere in general needs to be taken into account. Thus it is clear that proper price formation demands extremely broad information about all these matters.

Since most of this data is actually not strictly numerical, I think there is no point in making any other artificial restrictions to what the needed information actually consists of either. Instead, all information that anyone with an access to the market anywhere around the world possesses, should be included in the price-forming process. Especially in the global market the amount of this kind of information is extremely vast. Part of this information is relatively easily available for anyone. Part of it on the other hand is knowledge that cannot directly be accessed even by company insiders, but which may be accessed by some party interested in investing, who can thus benefit from this information. This kind of information would be the economical or consumer atmosphere in a certain market area, or knowledge about some kind of a potential scientific breakthrough for example.

When information is thought on a large scale like this, also the so-called insider information is just a small summary of sorts or a peek into an ocean of information. In principle it hardly brings any extra information, but in practice it may be a conclusive factor in the humanly restricted decision making.

Information in itself does not reflect any price, so also interpretation is needed for price formation. Thus, in order for the market to be fully efficient, the price has to be based on perfect interpretation as well. Just like the perfect information, also the perfect interpretation should be based on the best know-how that can be found in the world. This analysis would of course be an irrationally complicated process, which would include everything from microeconomy to macroeconomy, from predicting changes in the technological as well as the natural environment to predicting changes in the political decision making, population growth and social culture - along with of course assessing alternative investment possibilities and their relative profitability.

According to the efficient-market hypothesis, the efficiency should be there all the time no matter what the circumstances. Thus, when new information comes up, this should be instantly reflected in the price. This would mean that for example changes in currencies or raw materials prices should instantly be reflected to the whole market network through even the most indirect connections. In practice, even the collective intelligence of the world analysing such humongous networks of cause-and-effect might only succeed in a timespan of months or even years - and even then always imperfectly.

In addition to time, those who have the power to affect price formation should have enough motivation to study and analyse all relevant information. There is of course an inherent paradox related to this: there would never be adequate motivation, if the market would already price the security perfectly.

In addition to the abovementioned factors describing informational efficiency, there are also factors which should not disturb efficient price formation. There should under no circumstances be such external economical agents that would influence the core price formation. To elaborate, private investors in the core of the price formation should not have such strong and irrelevant motives that are based on economical pressure (eg. unemployment, disease, divorce) or need (eg. vacation, buying an appartment), or taxational factors, that they would make the price of the security sway from its true value.

The same of course applies to institutional investors, who actually have even stronger potential to shake up the price formation of securities. In a fully efficient market institutional investors would for example never make allocation changes in a way that would include ill-proportioned trades compared to the normal trading volumes of a specific stock. There should also be no asymmetrical bonus systems that give bonuses for extra profit but do not punish for losses to the same extent, since these kinds of moral hazards might cause an emphasis on the more risky securities.

Since the market basically consists of just people, one significant factor is market psychology, which directly affects the lowest level of efficiency, namely technical analysis or in other words predicting from past prices. This psychology has a few special features. In addition to the fact that people may predict the future of a company emotionally, people also speculate, what the others think about the future of a company. Moreover, people may also speculate, what the others might speculate. In the end some market movements may momentarily be based on mere speculation of speculation: no one believes that the real economy factor behind a movement would be as significant as the market reactions, but enough people believe that others believe in its adequate significance.

Another special feature is that even if a market reaction was not originally based on anything real, the psychology on the market may create a chain reaction that may have consequences in the real economy as well: once trust gets weaker, companies may invest less, which causes the trust to get even lower - and vice versa. As a result there may be strong overreactions in both directions, when fear or greed take over. However, true efficiency should be able to keep these feelings and overreactions at bay.

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