An efficient market means that asset prices quickly reflect new information, and the prices only react to surprising factors. The Nobel Prize Winner Eugene Fama proposed an efficient market hypothesis that divides the efficient market into three forms: weak, semi-strong and strong.
Three forms of efficient market
In weak form efficiency, the price of securities fully reflects all past market data, ie all historical prices and trading volumes. In this case, investors cannot predict future price movements by analyzing past prices or price patterns. Therefore, in weak form efficiency, technical analysis fails consistently produce anomalous risk-adjusted returns.
In semi-strong efficiency, the price of securities reflects all public information, namely financial statement figures and financial market data. By definition, the semi-strong form of efficient market contains a weak form of efficient market.Fundamental analysis helps to estimate the intrinsic value of assets. However, in semi-strong efficiency, the asset price has already reflected all the public information. Investors who try to analyze the public information are also unable consistently to produce anomalous risk-adjusted returns.
In strong form efficiency, the price of securities fully reflects public and private information. By definition, strong includes semi-strong and weak forms efficiency. In strong form efficiency, even insiders cannot use insider information to generate abnormal returns. However, since most countries prohibit insider trading, strong form efficiency is not common.
Is active investment dead?
The active investment assumes that not all information is fully reflected in the market price. If the securities market is in weak and semi-strong form efficiency, then active investment managers is unlikely to generate abnormal returns with the use of price pattern or public information. In other words, investors should invest passively.
For the efficient market, Edward Thorp, the father of quantitative finance, believes that the market is sometimes inefficient and thus provides an opportunity to beat the market. The reasons for this include the fact that investors sometimes behave irrationally, differences in market participants’ ability to process and analyze information, and price adjustments are not as fast as they might be. Thorpe advocates that if you would like to beat the market, you must train yourself to become a rational investor and in order to avoid overconfidence, you should constantly challenge your own ideas. Finally, when the opportunity comes, you need to react as fast as possible.
However, investment is not simply equal to beat the market. The key of the investment is to match investors’ objective and risk tolerance. Many investors tend to only look at performance but ignore risks. Therefore, it is advisable to carefully consider the whole investment plan and carry it out completely.