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Paul
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What does market efficiency mean?

October 14th, 2004, 8:34 am

Proposed by exotiq, seconded by wstguru.IMHO if you believe in market efficiency you really ought to get out more!P
 
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Anthis
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Joined: October 22nd, 2001, 10:06 am

What does market efficiency mean?

October 14th, 2004, 8:52 am

In plain words it means this: If you cant find and exploit inefficiencies then just hold the market/index
 
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DominicConnor
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What does market efficiency mean?

October 20th, 2004, 12:29 pm

Market efficiency might well be defined as how hard it is to make a riskless profit.
 
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wstguru
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What does market efficiency mean?

October 22nd, 2004, 5:32 pm

a theory that stipulates that asset prices reflect, at any time t, the information available in markets. and thus any investment can only return a fair profit respective to the risk taken and thus "beating the market" is something inexistant by definition.
 
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exotiq
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What does market efficiency mean?

October 24th, 2004, 1:31 pm

QuoteOriginally posted by: PaulIMHO if you believe in market efficiency you really ought to get out more!I smile to read you say that, Paul, since I have found two connections between getting out and believing in market efficiency:1.) Of the traders I know, the more experience they have, the more they seem to believe that one can't "beat the market".2.) The more I have believed in market efficiency, the more I have been able to get out and have a social life without worrying that I'm leaving money on the table back at my Bloomberg terminal.That said, market efficiency is probably as difficult to define as the existence of God, and similarly some of the definitions are falsifiable (at least statistically), and others are not.To start with, the three "MBA" forms of the efficient market hypothesis as best as I can paraphrase them from Malkiel's classic:*) Weak form: A trading strategy incorporating past price and volume information will not systematically outperform a buy-and-hold strategy.*) Semi-Strong form: A trading strategy incorporating current public fundamental information and past price/volume information will not systematically outperform a buy-and-hold strategy.*) Strong form: A trading strategy incorporating current private and public fundamental information and past price/volume information will not systematically outperform a buy-and-hold strategy.On falsifiability, Gordon Gecko and others might provide serious doubt for the strong form, and simple empirical backtests can provide statistical answers to the weak form. The Semi-strong form is much harder to prove or disprove because of the subjectivity and noise surrounding public fundamental information, and the difficulty of capturing all of these in a statistical test.A second line of thinking about efficiency is as a measure of the return on the cost of information:*) Sub-efficiency: It is possible to go out and make positive economic profit by aquiring information and trading on it. Hedge funds then have a role to go out and extract the value of this information.*) Efficiency: All traders, like any other business, make zero economic profit. Their business of arbitrage, correcting mispricings, and taking positions based on flow information is merely fair compensation for the service of providing liquidity to others. In particular, this is the service ETF and ADR arbitrageurs provide me by ensuring that the price of what I buy is in line with the underlying.*) Hyper-efficiency (thanks to Rubinstein): Broker's analysts and active fund investors should actually expect a negative return on their investment in information, since the extra returns from those "deeply buried tiny gold nuggets" does not offset the costs of obtaining them.Naturally, market efficiency also extends to the question of fair risk-return trade offs, and on the other end, the internal efficiency of trade execution.Some of the things market efficiency might mean are:- If markets are efficient, "smart" traders are hedgers, structurers, and market makers, and "smart" salespeople make money by charging excess fees on hedge funds, actively managed funds, and prop trading books to unsuspecting investors.- The alpha of funds is simply an illusion of selection and survivorship bias, or a mis-calculation of either the fund's beta, or how the "market portfolio" includes these businesses.Nonetheless, a reader can see that I do find the question a useful one to keep in the back of one's mind for taking market "opportunities" with the cautious grain of salt...
 
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farmer
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Joined: December 16th, 2002, 7:09 am

What does market efficiency mean?

October 24th, 2004, 2:22 pm

QuoteOriginally posted by: exotiq2.) The more I have believed in market efficiency, the more I have been able to get out and have a social life without worrying that I'm leaving money on the table back at my Bloomberg terminal.Of course it's not in your Bloomberg terminal. Pick up the phone, dial a random number, in a random country.Hello? Where are you? The building behind the gas depot at the Ministry of Defense?Do you own a car? Do you expect your children to own a car? Are you planning on buying a car, when do you expect the first person in your family to buy a car? How much money did you make last year, and how much money do you expect to make next year? Can you do math? Could your father do math? Are your children learning to do math, are they learning it at the same age, and going to the same kind of school, that you went to, that children went to last year, that children will go to next year? Do you have a savings, do you have a larger savings than you had last month, last year? Is your savings in paper currency, what nation? Do you plan on consuming more than you did last year? What is the first thing you are going to buy after hanging up the phone? What currency will you pay in, is one currency displacing another?That's new information, don't laugh at what John Zogby does for a living.As long as space isn't perfectly smooth, as long as there are random fluctuations in markets which don't arrive on a straight shot through space from the big bang, then the new information is somewhere on Earth, and a pipeline can be built from where it is to get to your office before it reaches the ticker. You can be along the path that is the shortest distance between two points.
 
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Fermion
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Joined: November 14th, 2002, 8:50 pm

What does market efficiency mean?

October 24th, 2004, 4:32 pm

Efficient market:By the time you are ready to trade a profitable opportunity you have identified, the market will have adjusted to take away the profit.Perhaps not a very useful definition for academics, but one that focusses on practical issues: to be a profitable trader you must get in there before the market.For the academic side of things, I tend to focus on the Markovian idea: An efficient market has no memory. (Which is also why I focus on non-Markovian models.)
 
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Gmike2000
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Joined: September 25th, 2003, 9:49 pm

What does market efficiency mean?

October 27th, 2004, 8:26 pm

Alpha is not an illusion or a sign of general market inefficiency. Alpha is measured with respect to an index. Who said the index is efficient? There are plenty of opportunities out there to outperform static indexes. As long as an index is just a subset of the WHOLE market (and by definition, most indexes are), it cannot be efficient and it can be outperformed very well.
 
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Munchkin
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Joined: April 23rd, 2003, 7:12 pm

What does market efficiency mean?

November 3rd, 2004, 6:23 pm

In his seminal paper Fama suggests that market is efficient if all information is fully reflected into prices. The way i understand this is that all invetors react to this information timeously and form the correct expectations based on this information (on average). This however leads to the problem of testability, since i do not believe that this claim is directly testable. How do we know what the expectations were at some point in time? Hindsight introduces a significant bias, so it is easy for some to claim tha the market was inefficeint in the 1990's. To me this might not neccessarily be true, since the expectations of the average investor in the 90's are unknown.The alternative is to test the claim that market participants can overperform the market consistently for greater periods of time then would be predicted probabilisticaly. So far, the evidence rejects this claim since (at least mutual funds managers) do not overperform the index benchmarks.This leads me to a question. Are there any good recent studies suggesting that this is not true for managers or traders? Do you think the average trader makes a profit purely from speculative activities (excluding profits made by dealing with customers)?
 
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balaji
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Joined: December 20th, 2003, 2:46 pm

What does market efficiency mean?

November 20th, 2004, 6:14 am

there is this Stiglitz's paradox as well. people need to believe otherwise for markets to stay efficient.
 
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exotiq
Posts: 1888
Joined: October 13th, 2003, 3:45 pm

What does market efficiency mean?

November 22nd, 2004, 1:52 pm

QuoteOriginally posted by: balajithere is this Stiglitz's paradox as well. people need to believe otherwise for markets to stay efficient.An idea that has fascinated me for a long time and has made me quite curious about how indexing will balance with active management in the future, how market costs are distributed between them, and how a combination between the two can resolve information problems in capital markets.Does anyone know a way to measure active versus "passive" investment activity, or how to quantify the critical level of active management there must be for markets to be efficient (that is, excess returns to average 0 or something like that)?One consequence I believe this would bring is how many hedge funds the market needs to be efficient, and at what level excess returns become negative...
 
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Rez
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Joined: May 28th, 2003, 9:27 pm

What does market efficiency mean?

December 9th, 2004, 12:54 am

I think that the following are also correct for efficient markets:1. In efficient markets all shares are perfect substitutes. 2. Both supply and demand curves are horizontal, coinciding at the equilibrium (market) price. Any amount can be sold or bought at that price. If S<>D even by the smallest amount, since they intersect at an 'infinite' quantity, an 'infinite' number of shares will be exchanged to 'correct' the deviation.K.
 
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Errrb
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Joined: December 17th, 2002, 4:18 pm

What does market efficiency mean?

December 21st, 2004, 12:57 am

Practical definition of market efficiency is the absence of predictable patterns that can be exploited for making money.
 
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yiLiTeQu
Posts: 18
Joined: November 20th, 2002, 5:48 pm

What does market efficiency mean?

February 3rd, 2005, 11:00 pm

The question then is, I guess, what do you mean by "absence " and "predictable patterns".QuoteOriginally posted by: ErrrbPractical definition of market efficiency is the absence of predictable patterns that can be exploited for making money.
 
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exotiq
Posts: 1888
Joined: October 13th, 2003, 3:45 pm

What does market efficiency mean?

February 10th, 2005, 2:00 am

Here are some direct questions I understand will separate who believes in market efficiency and by how much:1.) Active Management - Is it possible for hedge fund managers on average to beat the market? Is the alpha in hedge funds due to schmalpha (like selling deeply out of the money options and calling it all profit), or an illusion due to survivorship biases and lack of transparency? Do managers earn excess returns after fees? Do they even earn excess returns before fees? What about actively managed mutual funds? Why pay more than the absolute minimum expense ratio on the most diverse index fund?2.) Informational Advantage - Does market market efficiency mean that there is no advantage to being smart and no disadvantage to be being stupid with regard to selecting investments, and that matching risk/reward with investment suitability is the only actual value financial advisors can provide (or avoid straying from). Does any investment (stock, a hedge fund, an option, a piece of real estate, bonds, etc.) selected at random have a chance of outperforming or underperforming any other investment with a probability not statistically different from 50:50, possibly accounting for a risk premium over the long term?3.) Indexing - Does market efficiency mean that one index, composed of random weights in randomly selected investments, can not be expected to systematically outperform or underperform another (possibly accounting for a long-term risk premium)? Is the advantage of a larger index simply more diversification and less risk, and selection of any other index only a question of suitability, not performance?4.) Forecasting - Does efficiency imply that current market prices are the best possible predictors of future prices? For example, is the 3m Libor rate 10 years forward the actual expected value of 3m Libor in 10 years? I know Matthew has a J-curve dissagreement for applying this to FX.5.) Market Processes - In efficient markets, must the price processes of all tradeable assets be Markovian? Do prices and rates even have to follow a random walk? What are allowable models for trading costs and liquidity?That should be food for some thought...
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