What an efficient market is, and what makes one
KnownMemorizeWhat raises efficiency
| Factor | More efficient when |
|---|---|
| Participants | many active investors and analysts |
| Information | timely, accurate, equal access (disclosure rules) |
| Limits to trading | arbitrage and short selling are easy |
| Costs | trading and research costs are low |
Memory hook Who trades, what they know, what stops them, what it costs.
Know it cold Efficient = prices reflect new information quickly and rationally. A degree, not an on/off switch.
MemorizeValue and returns
| Term | Meaning |
|---|---|
| Market value | the price now |
| Intrinsic value | estimated true worth |
| Abnormal return | actual − expected (risk-adjusted) return |
Memory hook Price is what you pay, intrinsic value is what you get, abnormal return is what you beat.
Know it cold Only the unexpected part of news moves an efficient price.
Key terms
- informationally efficient market Memorize
- abnormal return Memorize
- market value Memorize
- intrinsic value Memorize
- active investment Use it
- passive investment Use it
- arbitrage Use it
- short selling Use it
- transaction costs Use it
- information-acquisition costs Use it
- Market participants Memorize more investors and more analyst coverage, so mispricings are found and traded away
- Information and disclosure Memorize timely, accurate, equally available to all
- Limits to trading Memorize arbitrage and short selling impeded, efficiency falls
- Costs Memorize prices are efficient within the bounds of what it costs to trade on them
- Transaction costs Use it commissions, spreads, price impact
- Information-acquisition costs Use it research, data, analysts
-
- Market value Memorize the price at which it can be bought or sold now
- Intrinsic value Memorize the value investors would place on it with a complete understanding; only ever an estimate
- Intrinsic above market looks undervalued, active investor buys
- Intrinsic below market looks overvalued, active investor sells or shorts
- Roughly equal market is efficient, passive investing makes sense
-
Formulas
Quick example
A share earns 10.2% in a year when its expected return, given its risk, was 7.5%. 10.2 − 7.5 = 2.7%.
- 10.2−7.5= 2.7
- 10.2ENTER7.5− 2.7
ENTER enter (on the HP, puts the number on the stack)
Quick example
Intrinsic value estimate 88.00, price 85.50, round-trip cost 1.2% of the price. Gap 2.50; cost 0.012 × 85.50 = 1.026. Net +1.474 per share.
- 88−85.5−(0.012×85.5)= 1.474
- 88ENTER85.5−0.012ENTER85.5×− 1.474
ENTER enter (on the HP, puts the number on the stack)