An efficient financial market processes the information available to investors and incorporates it into the prices of securities. Market efficiency has two general implications. First, in any given time period, a stock's abnormal return depends on information or news received by the market in that period. Second, an investor who uses the same information as the market cannot expect to earn abnormal returns. In other words, systems for playing the market are doomed to fail.
What information does the market use to determine prices? The weak form of the efficient market hypothesis says that the market uses the history of prices and is therefore efficient with respect to these past prices. This implies that stock selection based on patterns of past stock price movements is no better than random stock selection.
The semistrong form states that the market uses all publicly available information in setting prices.
Strong form efficiency states that the market uses all of the information that anybody knows about stocks, even inside information.
Much evidence from different financial markets supports weak form and semistrong form efficiency but not strong form efficiency.
Behavioral finance states that the market is not efficient. Adherents argue that:
Investors are not rational.
Deviations from rationality are similar across investors.
Arbitrage, being costly, will not eliminate inefficiencies.
Behaviorists point to many studies, including those showing that small stocks outperform large stocks, value stocks outperform growth stocks, and stock prices adjust slowly to earnings surprises, as empirical confirmation of their beliefs.
Four implications of market efficiency for corporate finance are:
Managers cannot fool the market through creative accounting.
Firms cannot successfully time issues of debt and equity.
Managers cannot profitably speculate in foreign currencies and other instruments.
Managers can reap many benefits by paying attention to market prices.
